Conventional Discounted Cash Flow Research Articles

A model for quantification of environmental risk in mining ventures

The premature termination of industrial projects, often triggered by insufficient revenue generation to cover liabilities, poses a significant challenge in project evaluation. Although the conventional discounted cash flow (DCF) method remains widely used, its inability to account for project failure probabilities can lead to resource misallocation. This study aims to address this limitation by applying real options theory to assess the risk of premature abandonment within the context of a mineral extraction project. In this proposed system, fluctuations in environmental remediation costs are modelled by considering the cumulative probabilities of cost increases or decreases at each time step. The simulated project value reflects the cumulative activities required for mine closure, where each ton of extracted ore generates an environmental liability demanding remediation. Through the application of this system, the study demonstrates its effectiveness in identifying an escalating probability of project closure over time. Particularly, the findings reveal the existence of a critical threshold date. Beyond this date, any operational suspension exceeding one year renders project closure the economically optimal choice. This closure encompasses all necessary environmental restoration activities. By integrating real options theory into project evaluation, this study offers a more comprehensive approach to assessing the risk of premature project abandonment in mineral extraction projects. Through the consideration of fluctuating environmental remediation costs and the cumulative probabilities of project closure, it provides valuable insights for decision-making in project management and resource allocation. The trigger curve generated allowed for the identification of the viability threshold of the venture. Identifying the threshold to initiate the mining closure project.

Uncertainty in firm valuation and a cross-sectional misvaluation measure

The degree of uncertainty associated with the value of a company plays a relevant role in valuation analysis. We propose an original and robust methodology for company market valuation, which replaces the traditional point estimate of the conventional Discounted Cash Flow model with a probability distribution of fair values that convey information about both the expected value of the company and its intrinsic uncertainty. Our methodology depends on two main ingredients: an econometric model for company revenues and a set of firm-specific balance sheet relations that are estimated using historical data. We explore the effectiveness and scope of our methodology through a series of statistical exercises on publicly traded U.S. companies. At the firm level, we show that the fair value distribution derived with our methodology constitutes a reliable predictor of the company’s future abnormal returns. At the market level, we show that a long-short valuation (LSV) factor, built using buy-sell recommendations based on the fair value distribution, contains information not accessible through the traditional market factors. The LSV factor significantly increases the explanatory and the predictive power of factor models estimated on portfolios and individual stock returns.

Economic Feasibility Study of a Chemical Enhanced Oil Recovery Project in Indonesia Based on Conventional Discounted Cash Flow (DCF) And Real Option Valuation Model: Case Study at PT ABC

Indonesia had become an oil exporter that is recognized by the world for many years and joined The Organization of Petroleum Export Community (OPEC) – an organization that controls petroleum production, supplies, and prices in the global market – in 1962. However, oil production in Indonesia has been decreasing from year to year, one of which is due to the lack of investment in the exploration of new oil wells in Indonesia so the majority of upstream oil and gas work in Indonesia is exploiting old wells which will naturally decline steadily. This resulted in Indonesia becoming a net import oil country in 2003. Therefore, additional operations are needed to maximize oil production from these existing wells, one of which is by conducting Chemical Enhanced Oil Recovery (CEOR). The main objective of EOR itself is to mobilize the remaining oil by enhancing the oil displacement and volumetric sweep efficiency. PT. ABC, a subsidiary of PT. XYZ (a state-owned company under SKK Migas and PT Pertamina supervision) which is engaged in the upstream sector in Indonesia, is assigned by the government to carry out one of the CEOR projects that have been determined by the Government. This research covers the economic feasibility of the CEOR Project based on the conventional Discounted Cash Flow (DCF) and Real Option Valuation (ROV) Model. The revenue-sharing policy used for the project economic calculation is the gross split method. The result of the economic analysis using the DCF method is the project is not economically feasible to run as the net present value (NPV) shows negative which is -2,911 MUSD. However, the real option valuation model helped increase the value to 11,416 MUSD by adopting a strategic option which is an option to delay and time flexibility into the project. As a result, the project could be economically feasible if the operation is deferred to the following year and the oil price is over 85.2 USD/BBL.

Economic Feasibility Study of a Chemical Enhanced Oil Recovery Project in Indonesia Based on Conventional Discounted Cash Flow (DCF) And Real Option Valuation Model: Case Study at PT ABC

Economic Feasibility Study of a Chemical Enhanced Oil Recovery Project in Indonesia Based on Conventional Discounted Cash Flow (DCF) And Real Option Valuation Model: Case Study at PT ABC

Determinants of Price Multiples for Technology Firms in Developed and Emerging Markets: Variable Selection Using Shrinkage Algorithm

Globally, technology firms are characterized by high level of innovation, rapid obsolescence of technologies, high investment risk and unpredictability of future cash flows. All these make conventional discounted cash flow valuation methods inadequate for valuation of technology firms. This study aims to develop sector regression models for relative valuation of technology firms by evaluating firm-level determinants of price multiples. Results suggest that price to book is the most appropriate multiple for valuing developed market technological firms, whereas price to sales is the most apt multiple for emerging market firms. Variable selection by least absolute shrinkage and selection operator (lasso) validates that growth rate, research intensity and cash holding influence value of price multiples for both developed market and emerging market firms. Similarly, smaller firms tend to generate higher value of the multiples under both categories. Firms’ ESG practices is an important determinant of price multiples for developed market firms, however, it does not influence the multiples’ value for emerging market firms.

Stock Recommendations from Stochastic Discounted Cash Flows

We present two stock recommendation systems based on stochastic characterization of firm present value that extends the conventional discounted cash flow analysis. The single-stock quantile recommendation system compares the market price of a company's stocks with the estimated distribution of the company's fair value to obtain an individual measure of mispricing, while the cross-sectional quantile system builds a relative measure of mispricing using the fair-value distribution of all firms. Both systems use mispricing information to build sell side and buy side portfolios. Statistical tests show that these portfolios consistently deliver significant excess returns even when rebalancing costs are accounted for. Moreover, we show how analysts' indications can be improved by using the first two moments of their recommendations following the same procedure of the cross-sectional quantile system.

Investigating the intertwining impact of wholesale access pricing and the commitment to net neutrality principle on European next-generation access networks private investment plans: An options-game application for capturing market players' competitive interactions

Whilst the deployment of next generation access networks (NGANs) is undoubtedly beneficial to the economy, new legal developments in the United States (US) regarding the issue of net neutrality (NN) pose a new challenge not only to policy makers but to telecommunication providers as well, that could justify a fresh approach when assessing NGANs investments. In particular, the Federal Communications Commission (FCC) subverted extant NN rules in the US and if the European Union (EU) decides to follow a similar deregulatory path in the future it could change the way telecommunications providers on both sides of the Atlantic lay down their optical-fibre network infrastructure investment plans. For instance, if traffic prioritization is allowed then diversification of revenue sources can be achieved by charging customers for privileged data delivery to their premises. Currently, NGANs roll-out throughout EU is an ongoing process in a setting whereby access regulation in the form of network element unbundling is already imposed. As a result, these legal developments form a new context within which it makes sense to assess the role of NGANs wholesale access pricing in tandem with the degree of commitment to NN rules so as to i) determine their combinatorial impact on private telecommunications operators' financial figures and ii) capture their competitive interactions. Towards this end, an important aspect of particular value to market players (i.e. incumbents and competitive providers – CPs), and policy makers (i.e. National Regulatory Authorities – NRAs) that this article aims to examine is how to employ the option-game (OG) analysis, that reflects the intersection of game theory (GT) and real options (ROs), to model the competitive interactions between participants in a particular competition game set-up by means of deriving possible Nash-equilibrium (NE) outcomes within a regulatory setting part of which is the commitment or non-commitment to the NN principle. This, hybrid, evaluation tool is applied on top of a conventional discounted cash flow (DCF) techno-economic analysis assessment of an NGAN investment opportunity.

Valuation Techniques and the Economics of Software as a Service

A significant amount of literature favors the notion that a real-options approach to capital budgeting is superior to the conventional discounted cash flow technique when uncertainty is present in the investment opportunity. Unlike traditional licensed-based software, SaaS1 inherently provides the buyer with the flexibility to change the course of the investment as uncertainty related to the product or service is resolved. In this respect, SaaS changes the game with regard to the economic benefits provided by the product or service. The SaaS model builds management flexibility into the investment decision and that same flexibility may be valuable when uncertainty is present. With that said, the question at hand is whether or not conventional valuation techniques such as DCF2 can be counted on to make accurate SaaS capital budgeting decisions. And if such methods cannot be counted on, do OPM3 techniques such as binomial lattices or modified Black Scholes models provide a more accurate picture of their value? The final and perhaps more important question seeks to understand which of the two methods is most likely to be used by finance professionals when making SaaS capital budgeting decisions. This paper will show that a considerable gap exists between those that intend to use conventional DCF models versus more sophisticated OPM techniques when making capital investment decisions that involve SaaS. This gap should be a concern for those that buy or sell products and services delivered via SaaS for the value of flexibility may go unrecognized.

PROJECT ECONOMIC EVALUATION OF LOW PERMEABILITY RESERVOIR DEVELOPMENT USING DISCOUNTED CASH FLOW METHOD AND REAL OPTION ANALYSIS FOR INVESTMENT DECISION

The oil potential from low quality reservoir of Field “X” is big and current recovery is not optimum yet. The typical low quality reservoir with low permeability characteristic is commonly not optimum if it is developed using common vertical well and horizontal well. These methods give low fluid rate deliverables that impact on low recovery and also operational challenges on artificial lift performance since not working on optimum range condition. To improve production performance and recovery, it is required the advanced method such as horizontal drilling using hydraulic multi step fracturing. However horizontal drilling using hydraulic multi step fracturing method need higher capital expenditure and more complex operational aspect during execution. On the current oil price condition, it is required comprehensive investment analysis for decision analysis consideration by performing oil price and investment cost sensitivity analysis, development scenario whether it is delay option, call option or put option. This research performs economic analysis using both Cost recovery PSC system and Gross Split PSC system. For economic analysis method, it use conventional Discounted Cash Flow (DCF) and Real Option to understand the value of flexibility that important for decision consideration.The economic analysis of low permeability reservoir development for 6 wells indicate that this project need 17.6 MM US$ capital expenditure, and will recover oil volume around 1.89 MMBO. Economic evaluation using DCF method with discount rate 10.8% indicate the economic indices for PSC Cost recovery (NPV = 6.08 MM US$, IRR= 28.9%, POT= 0.997 years, PI= 1.28 and Value Creation (VC) 10.65 MM US$) and for PSC Gross Split (NPV = 10.64 MM $US, IRR= 29.0%, POT= 1.517 years, PI= 1.49 and value creation (VC) 1.94 MM US$). Economic analysis using Real Option method with Black Scholes Merton (BSM) indicate that this project will deliver call option value around 9.8 MM US$ with value of flexibility around 3.7 MM US$ for PSC cost recovery. Meanwhile Real Option analysis for PSC gross split gives call option value around 10.7 MM US$ and value of flexibility around 4.1 MM US$. The 2 (two) methods recommend that this project economically feasible and suggest to execute the project as planned schedule (call to expand). According to the operational and economic assumption, it is suggested that Gross Split PSC system is potentially better on economic outcome than PSC cost recovery for the contractor (KKKS).

A jump-diffusion real option approach for hotel investment under uncertain lodging demand

PurposeOne of the important characteristics of the hotel business is uncertainty of lodging demand, which can jeopardize hotel operation and ultimately even threaten a hotel’s survival during an economic recession. The purpose of this paper is to propose an approach to determine optimal hotel investment issues under uncertain lodging demand.Design/methodology/approachUncertainty of lodging demand is classified into two types: the impact of unexpected economic recession and the temporary imbalance between supply of hotel rooms and lodging demand. A jump-diffusion real option approach is proposed to analyze how these two types affect optimal investment timing and the potential value of new hotel projects. The case of hotel investment in Macao is used to illustrate the jump-diffusion real option approach.FindingsThe results of numerical analysis show that the uncertainty induced by temporary imbalance between supply of hotel rooms and lodging demand increases the threshold of investment and hotel value, while the uncertainty induced by unexpected economic recession has ambiguous effects on the value and optimal investment timing of new hotel projects.Practical implicationsThe jump-diffusion real option approach increases managerial flexibility for managers when making investment decisions on new hotel projects, allowing greater value to be generated than is possible with the conventional discounted cash flow method.Originality/valueThe approach separates the impact of unexpected economic recession on lodging demand from that of “normal” fluctuations in lodging demand, and it considers the impact of both types of uncertainty on hotel investment.

The Discounted Cash Flow (DCF) Method Applied to Valuation: Too Many Uncomfortable Truths

The subprime crisis was an important wake up call for the financial discipline and the academic community. Several fundamental tenets of the field were called into question as the empirical evidence showed that they were less solid than previously believed. Currently, the list of issues under examination is long and challenging. It goes from basic ideas (are markets stable? are investors rational and homogeneous?) to more specialized topics (does the Value-at-Risk metric work? are credit ratings reliable?) The conventional Discounted Cash Flow (DCF) method -- since it did not play any role in the crisis -- has gone so far unexamined. Yet, with or without subprime crisis, it remains one of the weakest and most difficult to defend elements of the financial canon.

Real Options in Foreign Investment: A South American Case Study

The ability to make foreign acquisitions, especially into emerging markets, is now a core corporate skill. The quality of appraisals is a key part of this. We argue that foreign emerging market investment appraisal is often best carried out using a real options framework and structured as a series of investment options. The track record of foreign investment in practice has often been dismal. This is because emerging markets appraisals involve additional risks and far more complexity, so that valuing these investment proposals via conventional discounted cash flow approach is problematic. The core of the article is a case study, which recreates an investment in cinemas in Argentina, and serves as useful practical illustration of the use of real option in foreign investment appraisal. JEL classification: F36, F37, G12, G15, G34

The economics of an active solar heating system

The American University of Armenia recently installed a shower system in the ground floor of its building. In this note we examine the economic viability of using an active solar system to heat the showers. Using conventional discounted cash flow analysis as well as two other economic assessments of the capital investment, we demonstrate that it is economically justifiable to invest in a solar heating system based on the anticipated savings in heating costs over the lifetime of the system.

A numerical study for a mining project using real options valuation under commodity price uncertainty

Commodity price is an important factor for mining companies, as price volatility is a key parameter for mining project evaluation and investment decision making. The conventional discounted cash flow (DCF) methods are broadly used for mining project valuations, however, based on commodity price uncertainty and operational flexibilities, it is difficult and often inappropriate to determine mining project values through traditional DCF methods alone. In order to more accurately evaluate the economic viability of a mining project, the commodity price and its inherent volatility should be modelled appropriately and incorporated into the evaluation process. As a consequence, researchers and practitioners continue to develop and introduce real options valuation (ROV) methods for mining project evaluations under commodity price uncertainty, incorporating continuous time stochastic models. Although the concept of ROV arose a few decades ago, most of the models that have been developed to-date are generally limited to theoretical research and academia and consequently, the application of ROV methods remains poorly understood and often not used in mining project valuations. Analytical and numerical solutions derived through the application of ROV methods are rarely found in practice due to the complexity associated with solving the partial differential equations (PDE), which are dependent on several conditions and parameters. As a consequence, it may not generally be applicable to evaluate mining projects under all project-specific circumstances. Therefore, the greatest challenge to ROV modelling is in finding numerically explicit project values. This paper contributes towards the further development of known theoretical work and enhances an approach to approximating explicit numerical project values. Based on this work, it is possible to formulate more complex PDEs under additional uncertainties attached to the project and to approximate its numerical value or value ranges. To ensure the project is profitable and to reduce commodity price uncertainty, delta hedging and futures contracts have been used as options for deriving the PDE. Moreover, a new parameter for taxes has been incorporated within the PDE. This new PDE has been utilised to approximate the numerical values of a mining project considering a hypothetical gold mine as a case study. The explicit finite difference method (FDM) and MatLab software have been used and implemented to solve this PDE and to determine the numerical project values considering the available options associated with a mining project. In addition, commodity price volatility has been determined from historical data, and has again revealed price volatility as having a significant impact on mining project values.

Improving Economic Assessments of Clean Development Mechanism Projects Using Real Options

Currently, there is increasing pressure from global community to reduce the greenhouse gas emissions, the main cause of climate change. One of several programs to reduce the greenhouse gas is Clean Development Mechanism or CDM by the United Nation. The amount of greenhouse gas reduction through CDM projects in developing countries can be sold to developed countries so that they can increase the maximum cap of the emissions to be emitted into the environment. It is this carbon credit from CDM projects that is of financial value, and thus should be viewed as a new type of asset. This could help improve the financial outlook of CDM projects such as renewable energy generators (REGs) because not only these projects usually involve higher costs of technology but also high uncertainty from the prices fluctuation of input commodity, output products, and carbon credits, for instance. Valuing CDM projects full of uncertainty by conventional discounted cash flow (DCF) approaches such as net present value (NPV) could underestimate the intrinsic value and inherent risk of these projects. Accordingly, the aim of this paper is to propose a new approach for valuing the financial viability of CDM projects that considers risk, flexibility, and carbon credit into the economic analysis, using real options theory and risk-flexibility theory.

Valuing flexibilities in the design of urban water management systems

Climate change and rapid urbanization requires decision-makers to develop a long-term forward assessment on sustainable urban water management projects. This is further complicated by the difficulties of assessing sustainable designs and various design scenarios from an economic standpoint. A conventional valuation approach for urban water management projects, like Discounted Cash Flow (DCF) analysis, fails to incorporate uncertainties, such as amount of rainfall, unit cost of water, and other uncertainties associated with future changes in technological domains. Such approach also fails to include the value of flexibility, which enables managers to adapt and reconfigure systems over time as uncertainty unfolds.This work describes an integrated framework to value investments in urban water management systems under uncertainty. It also extends the conventional DCF analysis through explicit considerations of flexibility in systems design and management. The approach incorporates flexibility as intelligent decision-making mechanisms that enable systems to avoid future downside risks and increase opportunities for upside gains over a range of possible futures.A water catchment area in Singapore was chosen to assess the value of a flexible extension of standard drainage canals and a flexible deployment of a novel water catchment technology based on green roofs and porous pavements. Results show that integrating uncertainty and flexibility explicitly into the decision-making process can reduce initial capital expenditure, improve value for investment, and enable decision-makers to learn more about system requirements during the lifetime of the project.

Selection of the open pit mining cut-off grade strategy under price uncertainty using a risk based multi-criteria ranking system / Wybór strategii określania warunku opłacalności wydobycia w kopalniach odkrywkowych w warunkach niepewności cen w oparciu o wielokryterialny system rankingowy z uwzględnieniem czynników ryzyka

Abstract Cut-off Grade Strategy (COGS) is a concept that directly influences the financial, technical, economic, environmental, and legal issues in relation to exploitation of a mineral resource. A decision making system is proposed to select the best technically feasible COGS under price uncertainty. In the proposed system both the conventional discounted cash flow and modern simulation based real option valuations are used to evaluate the alternative strategies. Then the conventional expected value criterion and a multiple criteria ranking system were used to rank the strategies based on the two valuation methods. In the multiple criteria ranking system besides the expected value other stochastic orders expressing abilities of strategies in producing extra profits, minimizing losses and achieving the predefined goals of the exploitation strategy are considered. Finally, the best strategy is selected based on the overall average rank of strategies through all ranking systems. The proposed system was examined using the data of Sungun Copper Mine. To assess the merits of the alternatives better, ranking process was done at both high (prevailing economic condition) and low price conditions. Ranking results revealed that at different price conditions and valuation methods, different results would be obtained. It is concluded that these differences are due to the different behavior of the embedded option to close the mine early, which is more likely to be exercised under low price condition rather than high price condition. The proposed system would enhance the quality of decision making process by providing a more informative and certain platform for project evaluation.

What ethics lie Beyond Oil?

Abstract Companies’ responsibilities for safety are important social and environmental welfare concerns. This fictional case—inspired by actual events—presents a capital investment decision intended to improve oil refinery safety. Beyond Oil (BO), Inc. has a recently-acquired refinery that is in need of extensive modernization and repair. The case analysis requires you to integrate capital investment analysis methods with consideration of ethical responsibilities. You have the opportunity to consider how to incorporate both uncertainty and qualitative/strategic information into a conventional discounted cash flow (DCF) analysis and to weigh competing claims and conflicting incentives in order to make a recommendation.

On the decision of chlor-alkali process retrofit under environmental uncertainty: A real options approach

Increasing concerns over the release of mercury into the environment call for a cleaner production process in the chlor-alkali industry. Conventional discounted cash flow (DCF) appraisal does not account for the inherent strategic value of the project. Based on real optiontheory, this paper develops an evaluation model for estimating the threshold and timing that trigger a process retrofit project under environmental uncertainty. After conducting numerical and sensitivity analyses on significant factors that affect corporate process retrofit behavior, we have demonstrated that in the current environment and under current regulations, there are insufficient incentives to encourage firms to retrofit the mercury cell process, other than a significant increase in the environmental costs and/or strict enforcement of the current environmental policy. For a process that persistently emits toxic pollutants, it would be hoped that companies took a more socially responsible approach when considering the option of a process retrofdit.

Using Monte Carlo Simulation to Improve Ceramic R&D Investment Decisions

The success of ceramic companies is highly dependent on research and development (R&D). Thus, a pivotal aim of management is to allocate resources to the best scientific and financial R&D projects. But the valuation of ceramic R&D is a difficult task for managers. The conventional discounted cash flow (DCF) methods fail to consider the value of managerial flexibility provided by R&D projects. Real options Analysis (ROA) offers a superior way of capturing the value of flexibility. It enables decision-maker to value projects more accurately by incorporating managerial flexibilities into the valuation model. However, ROA can’t effectively deal with the volatility of parameters in itself under high uncertain circumstance. In view of the limitation of ROA, this paper uses Monte Carlo simulation to solve the parameters volatility problems. In the end, the case study proves that Monte Carlo simulation can improve R&D investment decisions, especially for highly unpredictable ceramic R&D projects.