Calculating a Discounted Cashflow (5) James Henderson The Economics of Energy Corporations (2) Outline of the course Overall objective – understand how senior management use economic models to make investment decisions 1.Introduction to key themes in the global energy market 2.Introduction to financial modelling as a management tool 1.Understanding some key concepts 3.Starting a model for a shale oil and gas field – revenues and prices 4.Inputting the costs – capital expenditure, operating costs and taxes 5.Calculating a discounted cashflow 1.Why is it important 2.How is it used to make decisions 6.Power plants – a gas-fired CCGT and a wind farm 7.Testing the investment decisions: running some numbers under different assumptions 8.Answering your questions Increasing interaction between prices of hydrocarbons The Discount Rate •A firm is like a pool of cash that has been financed from two sources – debt from banks and equity capital from shareholders • •Both sources of financing demand a return for providing cash • •Companies therefore need to at least recuperate their Weighted Average Cost of Capital from each investment they make – Firm Debt finance Equity finance Investment Cash Return on Investment Weighted Average Cost of Capital •WACC = [E/V * Re] + [D/V * Rd * (1-Tc)] • •E = firm’s equity, D = firm’s debt, V = total value of firm’s financing (V = E+D) • •Re = cost of equity, Rd = cost of debt • •Tc = corporate tax rate (firms can claim cost of interest against tax) Cost of Debt •How much does it cost to borrow money? • •Government borrowing rate (LIBOR) –US$ 4.6% (up from 1.75% 18 months ago) –UK£ 5.4% (up from 0.70%) • •Corporate borrowing rate (LIBOR + X%) –Depends on loan amount and credit worthiness of borrower –Ratings agencies provide assessments used by lenders • •Corporate bond rate (historic Eurobond offerings) –Gazprom 2017 Eurobond – 4.25% –BP 2017 US$ bond – 2.24% • •Interest payments are allowable for tax –Cost of debt = Interest rate x (1-tax rate) • • Yield on 10-Year US Treasury Bonds •Cost of borrowing reached a historic low during the COVID pandemic as Central Banks attempted to stimulate the economy •Rising inflation has led to a significant rebound in borrowing costs, which has a large impact on WACC calculations Increasing interaction between prices of hydrocarbons History of corporate borrowing costs •text Increasing interaction between prices of hydrocarbons Credit ratings impact the cost of debt, as well as investor preceptions Cost of Equity •What constitutes a return for a shareholder? –Dividends –Capital Growth –Total Shareholder Return – •Average cost of equity –The minimum acceptable return – the risk free rate –The premium for investing in the equity market (the extra return on the equity market compared to the risk free rate) –The specific premium for each company (the Beta) – how different is it to the market •Beta value is a measure of specific risk for a company – 1 is the market average •BP – 0.99; ExxonMobil - 0.84 •Sound Energy – 2.83; Chesapeake – 2.68 • •Risk free rate (LIBOR) + (Beta for a specific company * the equity market premium) » • Total return to shareholders •Almost no gain in share price terms over almost 20 years •Shareholders doubled their money when dividends and other incentives are included Annual performance of S&P 500 Index since 1872 •text Increasing interaction between prices of hydrocarbons More recent stock market returns •Average return in the period before COVID was just below 10% per annum (including dividends) •This is what shareholders expect from their investments in company shares Increasing interaction between prices of hydrocarbons MSCI World Index since 2008 •MSCI World Index captures performance of the main global equity markets •Includes total return – capital gain plus dividends •Average returns have been fairly consistent –Since 2009: 11.8% pa –Last 10 years: 10.6% pa –Last 5 years: 8.3% pa • Increasing interaction between prices of hydrocarbons The DCF Calculation as a foundation – WACC concept Image result for weighted average cost of capital Weighted average cost of capital is corporate “interest rate” WACC is the cost to a company of financing the capital for a project, including debt and equity Cost of debt = average interest rate for company Cost of equity is theoretical return to investors in the company Cost of Equity = Risk free rate + (Beta*(Market return – Risk free rate)) Essentially, how much return would an investor expect relative to putting his money with US Treasury stock, or in the stock market What is the Beta of a share? The Beta tells shareholders how much a share moves relative to the overall market Is it more or less volatile than the market as a whole? More volatile = more risky For more risk shareholders want more return A share with a Beta of 2 moves up and down twice as much as the market on average - market down by 2%, share down by 4% A share with a Beta of 0.5 moves half as much - market up by 10%, share up by 5% 1% 2% 1% 2% Yr4 Yr3 Yr2 Yr1 Increasing interaction between prices of hydrocarbons Range of company Betas •Analysis of 1768 companies on NYSE, NASDAQ and Amex exchanges in the US • •Highest concentration in the 0.51-1.50 range, with 1.01-1.25 having the largest number of companies for equity beta Increasing interaction between prices of hydrocarbons Betas across a number of industry sectors •Average upstream oil company Beta is 1.46 Increasing interaction between prices of hydrocarbons Analysis of Beta and Leverage (Debt to Equity) •Compare Betas across sector – see the higher risk industries • •D/E ratio explains how the companies are funded on average – the companies with higher Betas are able to raise less debt as a share of their capital • •Banks want to see shareholders taking most of the risk in higher Beta companies Industry Name Number of firms Beta D/E Ratio Oil/Gas (Integrated) 4 0.98 11.50% Oil/Gas (Production and Exploration) 174 1.26 20.08% Oil/Gas Distribution 23 0.99 71.41% Oilfield Svcs/Equip. 101 1.38 32.60% Power 48 0.73 77.16% Software (Internet) 33 1.55 17.66% Utility (General) 15 0.64 74.18% Source: NYU Stern, https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/Betas.html Increasing interaction between prices of hydrocarbons WACC Calculation Exxon •Debt/Equity – 70:30 •Equity Market return – 10.6% •Risk free rate – 4.61% •Beta – 0.91 •Cost of Equity •4.61 + (0.91 x (10.6 – 4.61)) = 4.61 + 5.45 = 10.06 • •Cost of Debt – 5.43% x (1-0.2) = 4.34% • •WACC calculation (10.06*0.3)+(4.34*0.7) =3.01% + 3.0% =6.01% • WACC Calculation Devon Energy •Debt/Equity – 30:70 •Equity Market return – 10.60% •Risk free rate – 4.61% •Beta – 2.32 •Cost of Equity •4.61 + (2.32 x (10.60 – 4.61)) = 4.61 + 13.89 = 18.51 • •Cost of Debt – 7.86% (LIBOR+3.25%) x (1-0.2) = 6.29% • •WACC calculation (18.51*0.7)+(6.29*0.3) =12.96% + 1.89% =14.85% • WACC Questions •Calculate the WACC based on the following assumptions: • •General –Risk-free rate – 4.5% –Equity market return – 10% –Corporate tax rate – 25% – •Specific –Company 1: Beta – 0.85, Interest rate on Debt – 3.5%, Share of Equity – 40% –Company 2: Beta – 1.75, Interest rate on Debt – 5%, Share of Equity – 30% –Company 3: Beta – 3.0, Interest rate on Debt – 7.5%, Share of Equity – 70% – •Double the Beta of Company 1. What happens to the WACC? –Do the same for company 3. What happens? – •In general, what is the optimal financing strategy for reducing WACC? –Can you think why it may or may not be possible to achieve this? – Internal Rate of Return •To calculate a NPV, we have to use a discount rate • •This rate is set by calculating the cost of capital, based on the expected rate of return expected by debt and equity investors • •But how high could this expected rate go before the NPV equals zero? • •This figure tells us the Internal Rate of Return (IRR) of the project –When the NPV is zero, it means that all the capital is repaid plus a certain level of return –As long as the IRR is higher than our discount rate, then the project will have a positive NPV and as reasonable rate of return Establishing the IRR of a project cashflow NPV = 0 Discount Rate Payback •How long does it take to recover the initial investment • •Measured in years (usually) but can be months for very rapid projects • •Can be calculated in simple or discounted terms –In other words either taking into account the time value of money or not Calculating Payback •US$30mm invested over three years • •Simple payback – US$30mm recovered after 1.5 years • •Discounted payback - $26mm recovered after 2 years