Discount Rates, Cost of Capital, and Property Acquisition Evaluations

Abstract

ABSTRACT The purpose of this paper is to examine the role of the discount rate in determining the fair market value of a producing oil and gas property; to assess the validity of a discount rate based on a derived source and on an observed or market source, and to evaluate the relationship between discount rates obtained from these two sources. The derivation of a discount rate based on a Cost of Capital approach is compared to the observed effective rate-of-return obtained from analysis of actual producing property acquisitions to (1) determine if a rational relationship occurs between discount rates obtained from the two methods, and (2) how the discount rates obtained from the two methods may reflect changes in the oil and gas industry. The use of derived and observed discount rates in FMV analysis is examined and discussed, particularly as it applies to property acquisitions.