The assignment includes analysis of cash flow of well drilling which includes analysis of horizontal and vertical drilling. In the given case, the discounted cash flow method has been used to understand the cash over the entire period of well drillings. The capital expenditure related to both frilling have been incurred at the beginning of the year and such cost will be amortised over the 10 years and 17 years of the life.
There are several methodologies to know the viability of the project. In the given case the Discounted cash flow method has been used. Under discounted cash flow method, the valuation of investment can be done on the basis of estimate future cash flows. It helps to know the value of investment on current time using the expected cash flow in future. Under this method, the present value of future cash flow needs to be calculated and such value shall be known as present value of the investment. Such method shall be used only in case where the investors pays on current but they expect to receive in future. The conclusion should be taken on the basis of present value of cash inflows. The project shall be considered as worthwhile only if the present value of the cash inflow is greater than the current value of investment. In case where the present value of the cash inflow is lower to current value of the investment, the opportunity need not to be considered.
Apart from discounted cash flow method, valuation can be done using the capitalisation method, market price, comparable method. In this case, it is not better to use the capitalisation method as the capitalisation method will be used in case where the company is in existence and served such project earlier. At the same time, it is very difficult to use the comparable method for valuation as it will not reflect actual position of the company’s finance. Accordingly, it is better to use the discounted cash flow method.
The net present value of cash flow of the vertical project is lower than horizontal project which indicates that the horizon project will generate more profit rather than vertical project. At the same time, it is observed from the DCF calculation that the company, under both drilling the value of cash flow becomes negative at the end of the project life. Accordingly, it is recommended that the company should continue with the horizontal well drilling rather than the vertical well drilling as it generates more cash flow in comparison of vertical well drillings.
As discounted cash flow method requires a lot of assumption which seems to errors in cash flows. There is need to predict cash flow which is not easy for experienced professional to earn maximum capacity.
This is very difficult to analyse the future cash on the basis of past data. Due to such even a small number of the difference in estimation may impact the large change in valuation. In addition to above, there is most difficult to understand whether the what rate should be taken as discounting factor. It plays important role. Increase in rate will reduce the value of cash flow at the same where the rate has been reduced, it will increase the value of the cash flow.
On the basis of above analysis, it is recommended that the valuation under this method should be done using the discount rate considering the economic condition, and subject to other condition. The future cash flows must be estimated by the experience professional so it can be ensuring that the data seem correct for valuation.
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