Phoenix Oil Plc - the Viability of the Falkland Alpha Reserve - Example

PHOENIX OIL PLC CASE Table of Contents Introduction 3 Financial Implications 4 Net Present Value(NPV) 4 Payback Period 5 Average Rate of Return (ARR) 6 Internal Rate of Return 6 Sensitivity Analysis 7 Asset Turnover 8 Oil Industry 9 Non-Financial Implications 9 Environmental Issues 10 Recommendation and Conclusion 10 Appendices & Calculation 10 Bibliography 13 Report To, Senior Managers Phoenix Oil PLC Subject: Report assessing the viability of the “Falkland Alpha” reserve Introduction Before Phoenix Oil PLC commences with the “Falkland Alpha” reserve project, it would be really beneficial if the feasibility of the entire project be evaluated. This project evaluation would help in identifying whether the business would be profitable or a disaster. The project would be analyzed by assessing both the financial and non-financial implications. With respect to the financial effects, the company’s project would be assessed using different financials techniques such as Net Present Value (NPV), Payback Period, Average Rate of Return (ARR), Internal Rate of Return (IRR) and Sensitivity Analysis. While assessing the non-financial factors, several issues would be considered such as the oil market, environmental issues and their consequences, political and other oil industry-wide issues. Financial Implications Net Present Value (NPV) Net Present Value is an analysis technique used to consider the financial implication of any business venture. NPV uses a discounting technique which is used to calculate the present value i.e. the present day value of any monetary sum to be received in future. NPV denotes the increase or decrease in the value of an organization at the present day as a consequence of accepting any project that is under review. The main advantage of the using the NPV technique is that it considers the present value of money. This present value is calculated by using an appropriate discount factor. A discount factor is calculated after analyzing the business and the industry risk of the organization in question. The setback of using the NPV technique is that it is difficult to calculate and that it makes it difficult to compare two different natured projects to be compared with one another. The ground decision rule with respect to NPV is to accept a project if it gives a positive NPV and decline a project in case of a negative NPV (Hansen et al, 2009). NPV – Falkland Alpha Since the survey cost of 1 million was already undertaken before initiating the project, it is considered to be a sunk cost and hence it would not be included while calculating the NPV of the project. Depreciation is not included while calculating NPV because it is a non-cash item and since no taxation effect is to be taken, tax savings would also be ignored in this case. Based upon the NPV calculations, the project seems worthwhile and hence it should be accepted. This conclusion is also based upon an assumption which states that the oil price per barrel should also remain above $100. Though this assumption may certainly remain intact considering the fact that oil has high value and demand around the globe; but there are certain possibilities that may lead to a decline within the oil prices and this may cause the NPV calculation to be unfavorable for Phoenix Oil PLC. Payback Period “Payback period is defined as that period in a project’s life cycle after which the cumulative annual cash inflow exceeds the expenditures for the project.” (Taylor, 2006) Payback period is also a finance technique that helps in assessing the feasibility of a project. Payback period gives an insight into the time duration during which the initial investment of a project would be recovered from the returns received from that project. Managers deciding on the Payback period basis usually follow their own instinct and the overall risk appetite of an organization when analyzing a project based on the Payback period. The criticism of the Payback technique is that ignores the time value of money and also overlooks the risk factor (Crosson& Needles, 2008). Payback Period – Falkland Alpha The payback period indicates that the Phoenix Oil PLC would be able to recover its initial investment after 6 years. This recovery would only be generated from the internal revenues generated from the commercial drilling of the oil in question. Average Rate of Return (ARR) Average Rate of Return (ARR) provides an idea of a project’s worth and its profitability over its useful life. It is usually calculated by dividing the initial investment by the annual expected profits. The relative merit of this technique is that it helps in meaningful comparison between similar companies. This measure is widely used around the globe it helps in easily assessing the overall business performance. The general decision rule with respect to ARR is to accept a project if it’s ARR is more than the Cost of Capital. Besides its merits, the technique has some drawbacks too. One of the major disadvantages of the ARR technique is that it is based on profits rather than real cash flows. Hence the technique has the susceptibility of being manipulated by managers in order to present better results of the company (Crosson& Needles, 2008). ARR – Falkland Alpha The ARR for the Falkland Alpha project is 7.83%. The decision whether to accept or reject the project in this case lies within the hands of the manager as it depends upon the risk appetite and the rate of return required by the investors of the company. If the Discount rate of 10% is the Cost of Capital for the company; the project should not be accepted (Anderson et al, 2008). Internal Rate of Return Internal Rate of Return, commonly mentioned as IRR, is a method used within capital budgeting in order to quantify and compare the profitability of investments. IRR is generally the discount rate that makes the present value of all cash flows equal to zero i.e. the present value of outflows equal the present value of inflows. Higher the IRR more would be the prospects of the considered project. The basic rule is that if the IRR is higher the company’s Cost of Capital, it should the accepted. “The IRR represents the highest rate of return an investor could afford to pay without losing money, if all the funds to finance the investment were borrowed and the loan was repaid by application of the cash proceeds from the investment as they were earned” (Bierman, 2010). IRR – Falkland Alpha The IRR for the Falkland Alpha project is 10.37%. Phoenix Oil PLC should undertake the project if their current cost of capital is lower than the aforementioned Internal Rate of Return. Sensitivity Analysis According to CIMA Official Terminology, “sensitivity analysis is a “modeling and risk assessment procedure in which changes are made to significant variables in order to determine the effect of these changes on the planned outcome” (Scarlett, 2003). The advantage of using this technique is that several possibilities are considered before final decision is taken. Many different variables are vastly analyzed and any changes brought upon by some altercations within those variables are properly investigated e.g. what effect would a change in the price of oil/barrel bring upon the revenue of the entire project. Sensitivity Analysis evaluates the change in percentage caused by a change in any particular variable; change that would have to occur before the real investment decision is changed. The Sensitivity is usually calculated with respect to some other variable in question. Sensitivity Analysis – Falkland Alpha According to the calculations, the most sensitive factor is the Equipment Cost. A 1.75% increase in the cost or value of the equipment would lead to changing the entire decision and thus it would also make the entire project as unprofitable and adverse for Phoenix Oil PLC. The second sensitive variable is the Expected Revenue factor. A 9.2% decrease in the expected revenue would also change the entire project’s picture. The project would have to be declined if the aforementioned change takes place. Exploration cost is the least sensitive variable compared to the other variables in question (Banerjee, 2010). Sensitivity analysis is hugely criticized for its complex nature of understanding and calculation. This method usually requires major grip over the technique and it is efficiently carried out with the help of simulation models and scenario building, which requires extensive knowledge and understanding of the technique in question. Asset Turnover Asset Turnover is yet another measure of profitability. “This ratio measures the relation between sales and the investment in Assets such as property, plant and equipment” (Stickney & Weil, 2007). This is a financial ratio that helps in measuring the efficiency of a company with respect to the usage of its assets i.e. generating revenue with the concerned assets. Higher the result of the ratio, better the efficiency i.e. more revenue would be generated by a company based upon its assets. The disadvantage of using this technique for appraisal is that it can give a distorted picture if the assets being used within the technique also comprise of assets which belong to any subsidiary company. Falkland Alpha Based upon the calculation, the asset turnover ratio would have to be calculated to other similar companies in order to ensure whether the performance of Phoenix Oil PLC is good or not. Oil Industry As mentioned, there is a strong assumption that the revenue would remain within the specified limit if the price per barrel of oil above $100. This assumption clearly creates a doubt and is something that may be outside the control of the financial managers of the company. Although the oil industry has recently not seen sharp changes, there are chances that the price per barrel may deviate from the aforementioned price. According to recent forecasts and results, the crude oil prices have swaggered around the $90 mark and it seems difficult that the crude oil price may increase really quick (Oil-price.net, 2012). Hence if this fact is considered, it seems that the sales prices mentioned would really be volatile and might not equal the forecasted amount. Non-Financial Implications Sole reliance on financial measures would certainly not provide an extensive insight to the entire project; hence it would be really useful if the Falkland Alpha project is also analyzed under some non-financial factors. The problem with sole reliance over financial measures is that they tend to have a shore-term view, have an internal focus with no consideration for external factors and that they have the vulnerability of being manipulated by financial managers. Following would some of the non-financial issues that would be analyzed with respect to the Falkland Alpha project. Environmental Issues Environmental issues are also a major concern while considering the Falkland Alpha project. Since the project relates to the oil industry, there are several laws and legislations that need to be considered before commencing the project. Failure to abide by such laws may also result in severe punishments such as hefty fines for a company. These fines would also thwart the company from successfully carrying on with the project. Recommendation and Conclusion Lack of non-financial evidence and information really restricts the conclusion to consider the non-financial implication properly. Another factor that is worth mentioning is the oil price/barrel. If extensive information with respect to the oil price/barrel would have been made available, a more resolute conclusion may have been reached. Although, if the financial implications are to be considered, the project seems worthwhile because of the positive results it fetches from the financial measures. Appendices & Calculation Firstly the entire project would be analyzed using financial techniques. To analyze the entire project’s financial effects, an expected value of the revenue would have to be calculated. Expected Value (EV) Extensive Reserve (9,000,000 * 0.2) + Limited Reserve (4,000,000 * 0.5) + Dry Reserve (0 * 0.3) EV or Expected Cash Inflows = £ 3,800,000 – This would be the expected revenue that would be generated annually from the oil business. Net Present Value Calculation – Falkland Alpha Year Description Cash Flows (‘000) Discount Factor (10%) Present Value (‘000) 0 Exploration Cost (3,000) 1.00 (3,000) 0 Equipment (20,000) 1.00 (20,000) 1-10 Expected Cash inflows 3,800 6.145 23,351 NPV 351 Payback Period Calculation – Falkland Alpha Payback Period = Investment required/ Net annual cash inflow Payback period = 23,000,000/ 3,800,000 = 6.05 Years Average Rate of Return - Falkland Alpha Average Rate of Return = Annual expected profits before interest and taxes/ Initial Investment * 100 It is assumed that the capital equipment would have no residual value at the end of Year 10. Annual expected profits before interest and tax = 3,800,000 – 2,000,000 (Annual depreciation of Equipment) = 1,800,000 ARR = (1,800,000)/ 23,000,000 * 100 = 7.83% Internal Rate of Return – Falkland Alpha NPV calculated at Discount Factor 12% Year Description Cash Flows (‘000) Discount Factor (12%) Present Value (‘000) 0 Exploration Cost (3,000) 1.00 (3,000) 0 Equipment (20,000) 1.00 (20,000) 1-10 Expected Cash inflows 3,800 5.650 21,470 NPV (1,530) IRR = L + NPVL/NPVL – NPVH * (H – L) L = Lower cost of capital H = Higher Cost of Capital NPVL = NPV at lower Cost of Capital NPVH = NPV at higher Cost of Capital IRR = 10% + {[351/ (351 – (-1530)]} * (12% - 10%) IRR = 10.37% Sensitivity Analysis – Falkland Alpha Sensitivity = NPV/ PV of flows under consideration Sensitivity to Exploration Cost = 351,000/ 3,000,000 * 100 = 11.7% Sensitivity to Equipment Cost = 351,000/ 20,000,000 * 100 = 1.75% Sensitivity to Expected Revenue = 351,000/ 3,800,000 * 100 = 9.2% Asset Turnover – Falkland Alpha Asset Turnover = Revenue/ Total Assets 3,800,000/ 20,000,000 = 0.19 Bibliography ANDERSON, D. R., SWEENEY, D. J., & WILLIAMS, T. A. (2008). Quantitative methods for business. Mason, OH.,Cengage Learning. BANERJEE, B. (2010). Financial policy and management accounting.New Delhi, Prentice Hall of India. BIERMAN, H. (2010). An introduction to accounting and managerial finance: a merger of equals. Singapore, World Scientific. CROSSON, S. V., & NEEDLES, B. E. (2008).Managerial accounting. Boston, MA, Houghton Mifflin Co. HANSEN, D. R., MOWEN, M. M., & GUAN, L. (2009). Cost management: accounting & control.Mason, OH, South-Western Cengage Learning. OIL-PRICES.NET. (2012). Crude oil and commodity Prices Retrieved from: http://www.oil-price.net/index.php?lang=en SCARLETT, B. (2003). The gentle touch.Technical, IDEC, CIMA Insider. Retrieved from: http://www.cimaglobal.com/Documents/Student%20docs/F3feb03fmarticle.pdf STICKNEY, C. P., & WEIL, R. L. (2007).Financial accounting: an introduction to concepts, methods, and uses. Mason, Ohio, Thomson/South-Western. TAYLOR, J. (2006). A survival guide for project managers. New York, AMACOM. Read More