Energy Sector Corporate Finance – The Investment Decision

Management must distribute limited resources to competing opportunities (projects) in the capital budgeting process. Making this investment, or capital allocation, we support management in estimating the value of each opportunity or project, which is a function of the size, timing and predictability of future cash flows.

Energy assets and infrastructure assets share the fact that the initial investment decision triggers a whole avalanche of life cycle cost. Unfortunately, few assets are decommissioned without painful write offs. The initial cost of building the asset very often accounts for more than 70 per cent of the life cycle cost. No cost cutting method can ever compensate a suboptimal investment decision.

In general, each projects’ value will be estimated using a discounted cash flow (DCF) valuation, and the opportunity with the highest net present value (NPV) will be selected. Other applied methods are visible from the DCF (they include discounted payback period, IRR, debt service coverage ratios, company added value, capital efficiency and ROI).

An added complication to strategic evaluation is the inclusion of all existing assets into the evaluation of new investment opportunities. Instead of looking at a discrete project, a company is actually looking at a portfolio of assets. Being in different phases of their life-cycle, these assets have the potential to compensate for each others’ risk profile, thus forming an internal insurance pool.

The complexity of authority procedures, site approval and building investments define the majority of life cycle costs. The additional (replacement) investments, expenses and revenues over the asset lifetime complement the life cycle calculation. Our Life Cycle Amortisation Modul (LCAM) is our tried and tested financial tool in this respect.

The LCAM provides the basis for a quantified risk analysis that reflects the impact of possible scenarios for the future. It enables the client to understand his asset portfolio which is equally his risk portfolio. The banker clearly wants to understand it too. It becomes a question of credit rating and bankability.

Our LCAM goes even further and functions as a key to the “holy grail of investment decisions” by valuing flexibility, “real options” and applying Monte Carlo scenario modelling.