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Good practice application of scenario and uncertainty analysis when using the DCF method

The ATO considers it to be good practice for valuers to reflect a series of discrete alternative field development plan scenarios and to reflect upon an appropriate weighting of those scenarios when arriving at the selected market value of resource projects. In addition the ATO considers it to be good practice for valuers to assess the impact of uncertainties in relation to key input parameters on the valuation range associated with each scenario.

The use of scenario and uncertainty analysis is particularly encouraged if valuers adopt the DCF valuation method when assessing the market value of earlier stage exploration and development properties. However, these analytical techniques are equally well suited to late stage development properties or properties in production as at 1 May 2010.

The ATO understands that there are various ways to account for uncertainty when using a DCF method. Whatever the basis for reflecting uncertainty, parameters should be fully disclosed to ensure transparency and replicability.

Real options/dynamic DCF method as a variant of the DCF method

The real options/dynamic DCF method involves the valuation of embedded options encountered by management when making the decision to invest in a petroleum project. The method uses the techniques applied to financial options to calculate the value of all the scenarios encountered during the decision making process, including the option of abandonment and the option of expansion. For example, the taxpayer's ability to delay its investment and operating decisions until the release of further material information is an option with value. The value of each option is calculated using risk-neutral probabilities, then discounted at the risk-free rate and totalled to determine the overall project's value.

Although the real options/dynamic DCF is an emerging valuation methodology which could be used to value a petroleum project, due to the highly complex nature of the method, caution needs to be taken to avoid incorrect valuations which may occur because of the high sensitivity to any variation in the assumptions. Given that real option pricing is based on a DCF calculation, the probability-weighted DCF is simpler to use as it can be applied to multiple scenarios to derive a valuation that is less sensitive to inaccuracies in the assumptions.

    Last modified: 03 Jul 2012QC 25073