Page 1

! The preference towards cash flow now rather than later

comes from:
! Ability to invest and earn interest on current income
! Uncertainty about the future
! Inbuilt human preference for consumption now versus later
! A discount rate is used to describe our time preference
towards income
! The higher the discount rate, the higher our preference
towards income now versus income later
The time value of money derives from the premise that cash flow
today is worth more than the same cash flow in the future
Time Value of Money
Page 2
Timing Drives Decisions
! Because of our preference for cash flow sooner, two factors drive our
investment decisions:
1. How much incremental cash flow do we generate?
2. What is the timing of the incremental cash flow?
! The importance of this second factor is governed by our discount
rate, which determines how much we will be prepared to pay to have
cash flow now as opposed to the future
The time value of money is one of the most important concepts to understand in
economic evaluations, since it is one of the largest drivers of decision-making
Illustration of time preference
You are guaranteed to receive $100
one year from now. How much are
you prepared to pay to have the
$100 now?
The money you are willing to pay is
essentially your discount rate.
So if you pay $5 (i.e. take $95 now),
then your discount rate is 5%.
Page 3
What Determines Discount Rates?
! Discount rates are determined by a number of factors:
! Cost of debt
! Cost of equity
! Attitude to risk and uncertainty
! Returns on current/future portfolio of assets
! Desired return on investment
! Discount rates in the oil industry range from 5% to 15%,
with the average around 10%
All oil companies use a discount rate in making investment decisions, but
discount rates vary across companies
Page 4
Which Discount Rate?
! A commonly used measure of discount rate is the Weighted Average
Cost of Capital (WACC)
! WACC is a measure of the minimum return a company must earn to satisfy
its existing shareholders and creditors
WACC = Cost of Equity x Proportion of Equity in Capital Structure +
Cost of Debt x Proportion of Debt in Capital Structure
Page 5
!"#$ % & ' ( ) *
+",-. +#0#.1" &%% &&% &'& &(( &)2
3.4"567".6 &%%
3.6"$"56 &% && &'8& &(8( &)82
9.: +#0#.1" &%% &&% &'& &(( &)2 &2&
How Do Discount Rates Work?
! The future value of an investment is determined by the amount
invested, PV, the rate of interest, r, and the period over which it is
invested n
! The future value (FV) of the investment at the end of period n can
be calculated by the following formula:
FV
n
=PV(1+r)
n
To understand discount rates we must first understand the concept of
compound interest rates
Future value = 100 x (1+.10)
5
= 100 x 1.61
= 161

Compound interest is calculated by
adding interest to the principal and
calculating interest on the combined total
Example: I invest $100 at 10% over 5 years. What is the future value of my investment?
-
200
400
600
800
1,000
1,200
1,400
1,600
1,800
2,000
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30
Years
$
FV Simple
FV Compound
Page 6
Introducing Discounting
! Generalizing our previous equation we have:
FV
n
= PV(1+r)
n

! PV stands for present value and represents the value of a
cash flow in the current period
! If we rearrange the equation we have:
PV = FV
n
x 1/(1+r)
n

! So we can adjust (or discount) a future cash flow by the
interest or discount rate to generate a present value, which can
be compared with current cash flow
Discounting means reducing the value of a future cash flow using an
appropriate discount rate
Page 7
Discounting Example
Example: I can invest money at an interest rate of 8%. Am I better
off accepting a cash flow of $100 now or $150 in five years time?
The present value of $150 in five years time:
= $150 / (1+8%)
5
= $150 / 1.47
= $102
The present value of $150 in five years has greater value
than $100 now so I should accept the $150 in five years
We now have a means of comparing a future cash flow with a
current cash flow, given an available interest rate
Page 8
! Assuming a series of future cash flows (FV
i
) the present
value (PV) is:
Present Value
Present value is the sum of a series of cash flows discounted to a
particular date using an appropriate discount rate
n
n
r
FV
r
FV
r
FV
r
FV
PV
) 1 (
...
) 1 ( ) 1 ( ) 1 (
3
3
2
2
1
1
+
+ +
+
+
+
+
+
=
The later the cash flow, the smaller the weighting, since the
discount factor decreases as we move further out in time
More weight Less weight
Page 9
!therefore the difference between cash flow and discounted
cash flow increases
Illustration of Discounting
10% discount rate
assumed
As we move further out in time the discount factor decreases!
Page 10
Alternatives
Option A

Option B

Year Cash Year Cash
1 $100 1 $1200
2 $200 2
3 $300 3
4 $400 4
5 $500 5

TOTAL $1500 TOTAL $1200

Which Option Is Better?
Page 11
r = Discount rate Factors
! Year 1 1/(1 + r)^1 = .952
! Year 2 1/(1 + r)^2 = .907
! Year 3 1/(1 + r)^3 = .864
! Year 4 1/(1 + r)^4 = .823
! Year 5 1/(1 + r)^5 = .784
At 5%: we apply .952 factor to 1st yr cash flow
.952 X 100 = 95 Option A
.952 X 1200 = 1143 Option B
Discount Factors at 5%
Then: .907 to 2
nd
year and so on
Then: sum our yearly discounted cash flows
1257 1143
A B
95 1143
181 0
259 0
329 0
392 0
Page 12
r = Discount rate Factors
! Year 1 1/(1 + r)^1 = .870
! Year 2 1/(1 + r)^2 = .756
! Year 3 1/(1 + r)^3 = .658
! Year 4 1/(1 + r)^4 = .572
! Year 5 1/(1 + r)^5 = .497
At 15%: we choose option B
WHY?
Discount Factors at 15%
913 1043
A B
87 1043
151 0
197 0
229 0
249 0
Page 13
! Our goal as a company is to increase shareholder
value
! The value metrics and decision criteria help optimize
investment decisions that contribute to this goal
! Measures are needed to answer two questions:
1. Does the project have economic merit?
2. Which competing project has the most merit?
! There is no one single metric that can always answer
these questions
Why Do We Need Value Metrics?
Page 14
Value Metrics
! Net Present Value (NPV)
! A measure of investment value after all costs, taxes and time value of
money have been taken into account
! Average Annual Rate of Return (AARR or IRR)
! Mathematically the discount rate that sets NPV=0
! Measure of the investment return, it can be compared to a defined
hurdle rate
! Profitability Index (PI) / Investment Efficiency
! Measure of investment efficiency or bang for buck
! A measure of the extent to which the value created exceeds the value
of the cash investment
! Cash Breakeven
! Measure of the length of time it takes for a project to recoup the
investment
Page 15
n
n
r
FV
r
FV
r
FV
r
FV
PV
) 1 (
...
) 1 ( ) 1 ( ) 1 (
3
3
2
2
1
1
+
+ +
+
+
+
+
+
=
NPV = Net present value
r = Corporate sanctioned discount rate
NPVr = Net present value at the discount rate
n = Year index
FVn = Cash flow in future years
Net Present Value
NPV measures the value created by an investment after all costs, taxes
and time value of money have been taken into account
NPV
Page 16
! NPV is the most commonly used investment
appraisal metric
! Measures the present value of the cash flows
generated by an investment, using a specified
discount rate
! Attaches greater weighting to earlier cash flows than
to later cash flows
! Can be used to compare the value generated by all
kinds of investments
Net Present Value
Decision criterion: projects with NPV greater than zero add value to the
company and should be recommended
Page 17
Net Present Value: Example
Do we buy a new P2000 pump unit? It costs $20,
but we could expect lower operating & maintenance
costs over the next 5 years.
Expected operating
costs without P2000
Year Cash Flow
1 $0
2 $100
3 $121
4 $136
5 $146

Expected opex &
investment w/P2000
Year Cash Flow
1 $20
2 $100
3 $115
4 $120
5 $120

Delta or Incremental
cash flows
Year Cash Flow
1 -$20
2 $0
3 $6
4 $16
5 $26

Yr1 Yr2 Yr3 Yr4 Yr5 Total
Disc Factors 10% .909 .826 .751 .683 .621
NCF -20 0 6 16 26
Disc NCF -18 0 4 11 16 13
Page 18
Year Cash Flow
1 $ -10
2 $ 10
3 $ 8
4 $ 5
5 $ 0

Net Present Value: Example
Should we buy either the Z1000 or P2000 pump?
Incremental cash flows
from Z1000 purchase
Do we buy a Z1000 Pump unit? It only costs $10, but
we could expect lower operating & maintenance
costs over the next 5 years.
Year DCF
1 $ -9
2 $ 8
3 $ 6
4 $ 3
5 $ 0

Total is 8
Page 19
Net Present Value: Example
! The present value of the P2000 is $13
! The present value of Z1000 is $8
! Both pumps are positive present worth investment so it
makes economic sense to buy them
! If capital is limited ! look at alternative investment
criteria
Page 20
Pros and Cons of NPV
Strengths:
! Shows scale of value generated
! Works correctly for any type of investment
! Easily interpreted and universally accepted
! Can be used to rank projects
Weaknesses:
! Does not show capital efficiency
! Discriminates against projects with long-life cash flows
! Difficult to compare projects of differing magnitudes
Page 21
Average Annual Rate of Return
Average annual rate of return (AARR) is the discount rate at which net
present value is equal to zero
AARR here is 30%
Page 22
Annual Average Rate of Return
Since inflows of cash occur after the investment period (outflows),
AARR is like a scale to balance the values of the inflows and
outflows of cash such that we are indifferent to the investment
NPV(10) = 340
Discount rate = 10%
NPV(20) = 0
Discount rate = 20%
AARR = 20% - the discount rate at which NPV = 0
Outflow
Inflow
Outflow
Inflow
NPV(10) = 340
Discount rate = 10%
NPV(20) = 0
Discount rate = 20%
AARR = 20% - the discount rate at which NPV = 0
Outflow
Inflow
Outflow
Inflow
Page 23
Average Annual Rate of Return
! Projects with AARR greater than our discount rate will
have, by definition, NPV greater than zero
! AARR provides a measure of the return on the
investment regardless of the size of investment
! Also referred to as Internal Rate of Return (IRR)
Decision criterion: projects with AARR greater than your discount rate add
value to the company and should be considered
Page 24
Pros and Cons of AARR
Strengths:
! Ties in with NPV
! Can be directly compared to a hurdle rate
! Allows project comparisons regardless of size
Weaknesses:
! Cannot be calculated on cash flows that are all positive or all negative
! Ignores project scale
! May have multiple solutions
Page 25
Profitability Index (PI) or
Investment Efficiency
) (
) (
CF Negative PV
CF Positive PV
PI =
Profitability Index measures the efficiency or bang for buck of an
investment. There are many different versions of investment efficiency.
Profitability index (PI) tells us how many discounted dollars of positive after-tax
cash we generate for every dollar of after-tax negative cash flow we invest
It is not a capital PI
Absolute value
Page 26
Profitability Index (PI)/Investment
Efficiency
! Projects with PI greater than one are NPV positive by
definition
! The same discount rate should be used for the PI
calculation as our NPV calculation
! We can use the NPV function in Excel to easily
calculate PI from our net cash flow
Decision criterion: projects with PI greater than one are NPV positive and
should be approved
Page 27
Profitability Index: Example
! Remember our pump example: Choose Z1000 or
P2000?
! Z1000 NPV $8 on $10 investment
! P2000 NPV $13 on $20 investment
! Appears that Z1000, despite lower NPV, gives a bigger
bang for the buck, lets do the math...
! Z1000 PI is 2.0 = 18 positives/9 negatives
IRR of 51%
! P2000 PI is 1.7 = 31 positives/18 negatives
IRR of 18%
! Need to look at projects over range of metrics
Page 28
Pros and Cons of PI/Investment
Efficiency
Strengths:
! Directly ties to NPV decision rule
! Indicates investment efficiency
! Can be used for ranking projects when cash is constrained
Weaknesses:
! Does not show absolute project scale
! Timing of positive cash flows can distort metric
! Time periods chosen can yield different results (monthly vs annual)
! Unable to calculate if all negative or positive cash flows
Page 29
! Number of years the project must operate as forecasted
to recoup the investment
! The shorter the cash breakeven period, the less the risk
to our investment and usually the better the value and
the rate of return
1 2 3 4 5 6
Net Cash Flow (5) (12) 4 8 15 10
Cumulative NCF (5) (17) (13) (5) 10 20
Cash Breakeven = 4.33
1 1 1 1 .33
Cash Breakeven (Time Period)
(15-10) / 15 = .33
Page 30
! Which pump had a better breakeven?
! Z1000 had cash flow of -10, +10.... So paid out in two
years vs P2000 which took almost 4 years
Cash Breakeven (Time Period)
Page 31
Pros and Cons of Cash Breakeven
Strengths:
! Useful for communicating cash management issues
! Ties in with political risk in overseas investments
Weaknesses:
! Ignores the time value of money
! Ignores all cash flows after breakeven year
! Only indirectly ties to project profitability
Page 32
Pump Decision-Putting It All Together
P2000
Year Cash Flow
1 -$20
2 $0
3 $6
4 $16
5 $26
Cash Flow $28
(Undiscounted)

NPV10 $13
IRR 18%
PI 1.7
Cash BE 3.9 Yrs
Z1000
Year Cash Flow
1 -$10
2 $10
3 $8
4 $5
5 $0
Cash Flow $13
(Undiscounted)

NPV10 $8
IRR 51%
PI 2.0
Cash BE 2 Yrs
Page 33
Agenda
" Introduction
" Cash Flow
" Time Value of Money/Metrics
# Uncertainty/Tools
$ Summary
Page 34
Uncertainty
! Uncertainty comes from
! What we know we don't know
! What we think we know but don't
! What we don't want to know
! What we could imagine but don't expect
! What we can't imagine!


! Role in project evaluation and decision making
! What to do?
! How to do It?
Page 35
! It is difficult to forecast the actual outcomes with a high
degree of confidence
! However, you can build a logically coherent picture
about any given set of outcomes (e.g. high prices, low
costs).
! You can also discuss the likelihood of these outcomes
! You can then talk coherently about these choices:
! Alternative ways of carrying out the project
! Alternative projects in which ConocoPhillips could invest
Addressing the Uncertainty
Page 36
! Prices
! Exchange rates
! Reserves
! Production rates
! Working interests
! Drilling costs
! Facilities costs
! Pipeline costs
! Variable opex
! Fixed opex
! Abandonment costs
! Inflation
! Royalty rates
Uncertainties Viewed By
An Economist:
! Tax Rates
! Contracts
! Competitors
! Political risk
! Tariffs
! Project Timing
! Depreciation
Page 37
Deterministic Economics
! Most project analysis begins with a deterministic model
! Enter inputs and technical, commercial and fiscal logic to
calculate a single outcome
! However, we make no statement about the likelihood of
the inputs or the outcome
! To view alternative results, you need to manually change the
inputs in the model
! Systematically investigating changing the inputs is known
as sensitivity analysis
! Running sensitivities to prices, costs, etc. gives good information
to the decision maker
! However, ad hoc sensitivities dont tell you anything about the
likelihood of an outcome
Page 38
CompanyNPV
85%
75%
85%
80%
60%
120%
125%
120%
120%
150%
(200) 0 200 400 600 800
reservesSens
priceSens
capexSens
taxSens
opexSens
Downside
Upside
Tornado Charts
! A tornado chart is a
way of graphically
demonstrating the
impact of changing a
single uncertainty on an
output value
! The uncertainty impacts
are sorted, highest to
the lowest
! Typically, the first three
or four uncertainties
contribute most of the
project variance
Larger
Smaller
Page 39
Probabilistic
Economics
! For more insight, we calculate a result and the
probability that a given result will occur
! We then systematically investigate feasible results
! We get useful information from the distribution of these
results and from various statistical measures
! Common techniques used to calculate probabilistic
outcomes are:
! Decision trees
! Monte Carlo simulation
Page 40
Decision Trees
What is a Decision Tree?
! A graphical means of
displaying key alternatives
and options available via a
chronological sequence of
decisions and uncertainties
Why create a Decision Tree?
! It structures the decision
process in an orderly fashion
! It is a diagnostic tool to map
how outcomes are generated
! It develops ranges of
outcomes using ranges for
input variables
! It communicates the
decision-making process to
management

P90
Drill Field? Reserves Oil Price Net Cash Flow
Time
P10
P50
30%
40%
30%
40%
(218)
P10
30%
(10)
251
P90
P10
P50
30%
40%
30%
217
522
907
P90
P10
P50
30%
40%
30%
798
1233
1780
30%
P50
P90
0
Yes
No
Page 41
Monte Carlo Analysis
! In Monte Carlo simulation, the discrete uncertainty inputs
are replaced by probability distribution functions
! The user then calculates the output over a large number
of times (say 1000), and calculates the statistics of the
output results (e.g. mean, median, P10 and P90)
! Monte Carlo simulations are very useful in giving the
likelihood of certain outcomes (e.g. while positive NPV,
this decision has a 60% chance of losing money)