American Institute of Mining, Metallurgical, and Petroleum Engineers, Inc.

This paper was prepared for the 49th Annual Fall Meeting of the Society of Petroleum Engineers of AIME, to be held in Houston, Texas, Oct. 6–9, 1974. Permission to copy is restricted to an abstract of not more than 300 words. illustrations may not be copied. The abstract should contain conspicuous acknowledgment of where and by whom the paper is presented. Publication elsewhere after publication in the JOURNAL paper is presented. Publication elsewhere after publication in the JOURNAL OF PETROLEUM TECHNOLOGY or the SOCIETY OF PETROLEUM ENGINEERS JOURNAL is usually granted upon request to the Editor of the appropriate journal provided agreement to give proper credit is made. provided agreement to give proper credit is made. Discussion of this paper is invited. Three copies of any discussion should be sent to the Society of Petroleum Engineers office. Such discussions may be presented at the above meeting and, with the paper, may be considered for publication in one of the two SPE magazines.

Abstract

The paper discusses the various aspects of engineering economy studies, including the meaning and significance of the interest rate used for discounting and the purposes of and differences between studies at project level and corporate level. The most common indices for project evaluation, discounted cash flow rate of project evaluation, discounted cash flow rate of return (DCFRR), present worth (PW), and uniform annual cost (UAC), as well as several-dual investment methods, are examined conceptually (rather than mathematically) and in example. The conclusions drawn are (1) methods applicable to project optimization studies generally are not applicable to corporate optimization studies; (2) for studies at project level, DCFRR, PW, and UAC do as good a job as can be expected from any index; (3) various methods that explicitly consider reinvestment add nothing useful to project analysis and fail to consider certain factors essential in corporate optimization studies; and (4) the standard techniques, particularly DCFRR, have suffered from considerable unjust and incorrect criticism.

Introduction

An investment, to be justified, must generate sufficient revenue to cover expenses, taxes, recovery of capital, and a reasonable return It is the purpose of an economy study to estimate how well each proposal does this.

An economy study of a prospect involves three phases of investigation.

  1. Initial screening: This is a determination of whether or not the venture meets minimum profit requirements. Those that fail to meet this requirement are rejected; those that meet or exceed it are examined further.

  2. Comparison: The purposes of this segment of the study are to (1) compare various proposals for doing the same job (mutually proposals for doing the same job (mutually exclusive alternatives) and select the most profitable, or least costly, and (2) compare profitable, or least costly, and (2) compare accepted projects and develop an initial order of desirability to establish the priority for funds (budget optimization).

  3. Placement: This phase considers projects in the light of their over-all impact projects in the light of their over-all impact on financial structure and their position with respect to corporate goals. The placement establishes the order of preference among acceptable investments.

Screening and comparison concern themselves mainly with project optimization and are a design or department-level function.

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