An Alternative Concept of Investment for Improved Profitability Measures

Abstract

Summary Discounted cash flow methods for evaluating investment opportunities enjoy wide use in the petroleum industry. The two most popular measures are net present value and internal rate of return. While these two measures are generally suitable as accept/reject criteria, they are not so useful in capital rationing situations, where a ranking of projects is required. Decades ago authorities suggested that the net present value divided by the initial outlay is a better measure for ranking projects. This kind of measure becomes more difficult to apply correctly when ail the capital costs in a project are not incurred up front, but are spread over a number of years. It is common practice to discount these future capital outlays back to the present and include them in investment (the divisor in the index). Simple examples demonstrate, however, that some obviously erroneous rankings can result from this procedure. By using an alternative definition of project investment, based only on the project net cash flows and the discount rate, we can avoid these pitfalls and obtain a better profitability measure for ranking projects.