Project Economics

Net Present Value Analysis

Evaluate pipeline and midstream project economics using NPV, IRR, and discounted cash flow analysis with WACC-based discount rates for capital investment decisions.

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NPV decision rule

NPV > 0: Accept

Positive NPV means project returns exceed cost of capital; creates shareholder value.

Typical discount rate

8–12% WACC

Midstream companies use 8-12% discount rate based on WACC and project risk.

Project life

20–30 years

Pipeline projects evaluated over 20-30 year economic life with salvage value.

Contents

Use this guide when you need to:

  • Calculate NPV and IRR for capital projects.
  • Determine appropriate discount rate (WACC).
  • Perform sensitivity and risk analysis.

1. Overview & Concepts

Net Present Value (NPV) analysis is the fundamental method for evaluating capital investments in pipeline and midstream projects. NPV quantifies project value by discounting future cash flows to present value using the company's cost of capital.

Time value of money

Present value concept

Dollar today worth more than dollar tomorrow due to earning potential and risk.

Investment decision

Accept if NPV > 0

Positive NPV means project returns exceed required return; creates value.

Ranking projects

Higher NPV preferred

Among mutually exclusive projects, select highest NPV option.

Capital budgeting

Portfolio optimization

Allocate limited capital to projects with highest NPV per dollar invested.

Key Financial Metrics

  • NPV (Net Present Value): Sum of discounted cash flows minus initial investment; measures absolute dollar value creation
  • IRR (Internal Rate of Return): Discount rate that makes NPV = 0; measures percentage return
  • PI (Profitability Index): NPV / Initial Investment; measures value per dollar invested
  • Payback Period: Years to recover initial investment (see payback-analysis-fundamentals.html)
  • WACC (Weighted Average Cost of Capital): Company's blended cost of debt and equity financing
Why NPV is preferred: NPV directly measures dollar value created, accounts for all cash flows, incorporates time value of money, and uses realistic discount rate (WACC). Superior to payback period or accounting rate of return for capital budgeting decisions.

NPV Decision Framework

NPV Result Meaning Decision
NPV > 0 Project returns exceed cost of capital Accept - creates shareholder value
NPV = 0 Project returns equal cost of capital Indifferent - no value creation/destruction
NPV < 0 Project returns below cost of capital Reject - destroys shareholder value
NPV₁ > NPV₂ Mutually exclusive projects Select Project 1 (higher NPV)

Types of Cash Flows

Project cash flow timeline showing Year 0 CAPEX outflow of -$10M in red, Years 1-10 annual operating cash flows of +$2M in green, and final year salvage value of +$1M in blue, with NPV formula displayed
Project cash flow timeline illustrating initial investment, annual operating cash flows, and terminal salvage value used in NPV calculations.
  • Initial investment (Year 0): Capital expenditure (CAPEX) - pipeline construction, equipment, land, permits
  • Operating cash flows (Years 1-N): Revenue minus operating expenses (OPEX), fuel, labor, maintenance
  • Terminal cash flow (Year N): Salvage value, working capital recovery, decommissioning costs
  • Tax effects: Depreciation tax shield, capital gains/losses on disposal

Common Pipeline Investment Types

Project Type Typical Investment Cash Flow Profile Project Life
Greenfield transmission pipeline $500M - $5B Large upfront CAPEX, stable long-term revenue 30-50 years
Lateral extension $10M - $100M Moderate CAPEX, incremental revenue 20-30 years
Compressor station upgrade $20M - $200M CAPEX, reduced fuel costs, increased capacity 15-25 years
Integrity/replacement $5M - $50M CAPEX, avoided failure costs, maintained revenue 10-20 years
Metering/automation $1M - $10M CAPEX, reduced labor, improved accuracy 10-15 years

2. NPV Calculation

NPV equals the sum of all future cash flows discounted to present value minus the initial investment.

NPV Formula

Net Present Value: NPV = Σ [CF_t / (1 + r)^t] - Initial Investment Or expanded: NPV = -CF₀ + CF₁/(1+r)¹ + CF₂/(1+r)² + ... + CF_N/(1+r)^N Where: NPV = Net present value ($) CF_t = Cash flow in year t ($) r = Discount rate (WACC, decimal) t = Time period (years) N = Project life (years) CF₀ = Initial investment (negative cash flow) Alternative form with salvage value: NPV = -I₀ + Σ(t=1 to N) [CF_t/(1+r)^t] + S_N/(1+r)^N Where: I₀ = Initial investment S_N = Salvage value at end of year N

Discount Factor

Present Value Factor: PV Factor = 1 / (1 + r)^t This is the present value of $1 received in year t. Example discount factors at r = 10%: Year 1: PV = 1/1.10 = 0.9091 (each dollar worth $0.91 today) Year 5: PV = 1/(1.10)^5 = 0.6209 Year 10: PV = 1/(1.10)^10 = 0.3855 Year 20: PV = 1/(1.10)^20 = 0.1486 Note: Distant cash flows heavily discounted (Year 20 dollar worth only $0.15 today)

Example Calculation - Pipeline Lateral

Example: 20-Mile Lateral Extension Initial investment (Year 0): - Pipeline construction: $25M - Compressor station: $10M - Land and permits: $2M Total CAPEX: I₀ = -$37M Annual cash flows (Years 1-20): - Revenue (tariff): $8M/year - Operating expenses: -$2M/year - Net annual cash flow: CF = $6M/year Discount rate: r = 10% (WACC) Salvage value (Year 20): S = $5M NPV Calculation: Method 1: Year-by-year NPV = -37 + 6/(1.10)¹ + 6/(1.10)² + ... + 6/(1.10)²⁰ + 5/(1.10)²⁰ Method 2: Annuity formula (equal cash flows) PV of annuity = CF × [(1 - (1+r)^-N) / r] PV of annuity = 6 × [(1 - 1.10^-20) / 0.10] PV of annuity = 6 × [0.8514 / 0.10] PV of annuity = 6 × 8.514 = $51.08M PV of salvage = 5 / (1.10)^20 = 5 × 0.1486 = $0.74M NPV = -37 + 51.08 + 0.74 = $14.82M Decision: Accept project (NPV > 0, creates $14.82M value)

Internal Rate of Return (IRR)

IRR is the discount rate that makes NPV = 0:

IRR Definition: Find IRR such that: NPV = 0 = Σ [CF_t / (1 + IRR)^t] - I₀ For the lateral example above: 0 = -37 + 6/(1+IRR)¹ + 6/(1+IRR)² + ... + 6/(1+IRR)²⁰ + 5/(1+IRR)²⁰ Solve iteratively (trial and error or Excel IRR function): IRR = 15.1% Decision rule: If IRR > WACC (15.1% > 10%), accept project ✓ If IRR < WACC, reject project Note: IRR = 15.1% means project returns 15.1% annually, exceeding 10% cost of capital by 5.1 percentage points.

Profitability Index

Profitability Index (PI): PI = NPV / Initial Investment Or: PI = PV(Cash Inflows) / PV(Cash Outflows) For lateral example: PI = 14.82 / 37 = 0.40 = 40% Interpretation: Every $1 invested creates $0.40 of value Or: PV of inflows is 1.40× initial investment Decision rule: PI > 0: Accept (equivalent to NPV > 0) PI < 0: Reject Use for capital rationing: Rank projects by PI when budget limited

Unequal Cash Flows

Many projects have varying cash flows over time:

Example: Compressor Station with Increasing Tariffs Year 0: CAPEX = -$50M Year 1-5: CF = $8M/year Year 6-10: CF = $10M/year (tariff increase) Year 11-15: CF = $12M/year Year 15: Salvage = $8M Discount rate: r = 9% Calculate NPV by summing discounted cash flows: Years 1-5: PV = 8 × [(1-1.09^-5)/0.09] = 8 × 3.8897 = $31.12M Years 6-10: PV = 10 × [(1-1.09^-5)/0.09] × (1.09)^-5 = 10 × 3.8897 × 0.6499 = $25.28M Years 11-15: PV = 12 × [(1-1.09^-5)/0.09] × (1.09)^-10 = 12 × 3.8897 × 0.4224 = $19.72M Salvage: PV = 8 / (1.09)^15 = 8 × 0.2745 = $2.20M NPV = -50 + 31.12 + 25.28 + 19.72 + 2.20 = $28.32M ✓ Project highly attractive with NPV = $28M
NPV sensitivity to discount rate chart showing NPV curve from +$12M at 0% to negative at 30%, with IRR at 18% where curve crosses zero, WACC at 10% marked with NPV of $4.2M, green shaded positive NPV region and red shaded negative region
NPV profile showing how net present value decreases as discount rate increases, crossing zero at the internal rate of return (IRR = 18%).

Mid-Year Convention

For more accuracy, assume cash flows occur mid-year instead of year-end:

Mid-Year Discounting: Standard (year-end): PV = CF / (1+r)^t Mid-year: PV = CF / (1+r)^(t-0.5) Effect: Increases NPV slightly (cash received sooner) For Year 1 cash flow at 10% discount: Year-end PV: CF / 1.10 = 0.9091 × CF Mid-year PV: CF / 1.10^0.5 = CF / 1.0488 = 0.9535 × CF Difference: ~4.8% higher PV with mid-year convention Use mid-year for monthly/continuous cash flows (tariff revenue) Use year-end for annual lump sums (tax payments)

Common NPV Pitfalls

  • Ignoring taxes: Use after-tax cash flows; depreciation creates tax shield
  • Sunk costs: Exclude past expenditures (e.g., feasibility studies already paid)
  • Allocated overhead: Include only incremental costs caused by project
  • Inflation: Match nominal cash flows with nominal discount rate, or real with real
  • Working capital: Include working capital investment and recovery
  • Opportunity cost: Include forgone alternatives (e.g., land could be sold)
Tax considerations: Pipelines use MACRS depreciation (15-year or 20-year property). Depreciation is non-cash expense that reduces taxable income, creating tax shield. Tax shield value = Depreciation × Tax Rate. Must include in cash flow analysis.

3. Discount Rate & WACC

The discount rate represents the opportunity cost of capital - the return investors could earn on alternative investments of similar risk. WACC is the most common discount rate for corporate investments.

Weighted Average Cost of Capital (WACC)

WACC Formula: WACC = (E/V) × r_e + (D/V) × r_d × (1 - T_c) Where: WACC = Weighted average cost of capital E = Market value of equity D = Market value of debt V = E + D = Total firm value r_e = Cost of equity (required return on equity) r_d = Cost of debt (interest rate on debt) T_c = Corporate tax rate (1 - T_c) = Tax shield on debt interest Interpretation: - First term: Cost of equity, weighted by equity proportion - Second term: After-tax cost of debt, weighted by debt proportion - Debt is tax-deductible, so after-tax cost is r_d × (1-T_c)

Cost of Equity - CAPM

Cost of equity calculated using Capital Asset Pricing Model:

CAPM (Capital Asset Pricing Model): r_e = r_f + β × (r_m - r_f) Where: r_e = Required return on equity (cost of equity) r_f = Risk-free rate (10-year Treasury yield, ~4-5%) β = Beta (stock volatility relative to market) r_m = Expected market return (~10-12% historical) (r_m - r_f) = Equity risk premium (~6-8%) For midstream companies: r_f = 4.5% (10-year Treasury) β = 0.8 - 1.2 (midstream typically lower than market) r_m - r_f = 7% (equity risk premium) Example: β = 1.0 r_e = 4.5% + 1.0 × 7% = 11.5%

Cost of Debt

Cost of Debt: r_d = Yield to maturity on company's long-term bonds Or if no bonds outstanding: r_d = r_f + Credit spread Credit spreads for midstream (BBB rated): - Investment grade: 1.5-3.0% above Treasury - High yield: 3.0-6.0% above Treasury Example: 10-year Treasury = 4.5% BBB credit spread = 2.0% r_d = 4.5% + 2.0% = 6.5% After-tax cost (at 25% tax rate): r_d(1-T_c) = 6.5% × (1-0.25) = 4.875%

WACC Calculation Example

Example: Midstream Company WACC Capital structure: Market value of equity: E = $10B Market value of debt: D = $5B Total value: V = $15B Equity weight: E/V = 10/15 = 66.7% Debt weight: D/V = 5/15 = 33.3% Cost of equity (from CAPM): r_e = 4.5% + 1.0 × 7% = 11.5% Cost of debt: r_d = 6.5% (yield on company bonds) Tax rate: T_c = 25% After-tax: r_d(1-T_c) = 6.5% × 0.75 = 4.875% WACC: WACC = 0.667 × 11.5% + 0.333 × 4.875% WACC = 7.67% + 1.62% WACC = 9.29% Round to: WACC ≈ 9% for project evaluation

Typical WACC by Industry

Industry Segment Typical WACC Risk Characteristics
Regulated pipelines (interstate) 7-9% Low risk, stable tariffs, regulatory protection
Gathering & processing 9-11% Moderate risk, commodity price exposure
Midstream MLPs 8-10% Fee-based, long-term contracts
Export terminals (LNG) 10-12% Higher risk, international exposure, large CAPEX
E&P (upstream) 12-15% High risk, commodity price volatility

Project-Specific Risk Adjustment

Adjust WACC for project risk relative to company average:

Risk-Adjusted Discount Rate: r_project = WACC + Risk Premium Typical risk premiums: - Replacement/integrity (low risk): WACC - 1% to WACC - Expansion (moderate risk): WACC to WACC + 2% - Greenfield (high risk): WACC + 2% to WACC + 5% - International/frontier (very high): WACC + 5% to WACC + 10% Example: Company WACC = 9% Greenfield pipeline in stable market: 9% + 2% = 11% Compressor station replacement: 9% - 0% = 9% International project (political risk): 9% + 7% = 16%

Real vs. Nominal Rates

Fisher Equation: (1 + r_nominal) = (1 + r_real) × (1 + inflation) Or approximately: r_nominal ≈ r_real + inflation Where: r_nominal = Nominal discount rate (includes inflation) r_real = Real discount rate (inflation-adjusted) inflation = Expected inflation rate Example: If WACC = 9% nominal and inflation = 2.5% r_real = (1.09 / 1.025) - 1 = 6.34% Consistency requirement: - Nominal cash flows → use nominal discount rate - Real cash flows → use real discount rate Most corporate analyses use nominal rates and nominal cash flows
WACC limitations: WACC assumes constant capital structure and risk over project life. For projects that change company risk profile or financing, use APV (Adjusted Present Value) method. For very long projects (30+ years), consider declining discount rate (lower rates for distant cash flows).

4. Sensitivity Analysis

Sensitivity analysis examines how NPV changes when key assumptions vary. Essential for understanding project risk and identifying critical success factors.

One-Way Sensitivity

Vary one input at a time while holding others constant:

Example: Pipeline Lateral Sensitivity Base case: - Initial investment: $37M - Annual revenue: $8M - Annual OPEX: $2M - Discount rate: 10% - Project life: 20 years - Base NPV: $14.82M Sensitivity to revenue (±20%): Revenue at $6.4M/yr (-20%): NPV = -$2.26M (REJECT) Revenue at $8.0M/yr (base): NPV = $14.82M Revenue at $9.6M/yr (+20%): NPV = $31.90M Sensitivity to discount rate: At 8% WACC: NPV = $21.63M At 10% WACC (base): NPV = $14.82M At 12% WACC: NPV = $9.17M At 15% WACC: NPV = $0.40M (barely positive) Critical insight: Project very sensitive to revenue; less sensitive to WACC

Tornado Diagram

Bar chart showing impact of each variable on NPV:

NPV sensitivity tornado diagram showing horizontal bars for each variable extending from base case NPV of $4.2M, with gas price having largest impact ($1.5M to $7.0M), followed by production volume, CAPEX, operating cost, discount rate, and project life
Tornado diagram ranking input variables by their impact on NPV. Gas price and production volume are the most sensitive variables requiring careful estimation.
Variable Low Case NPV Base NPV High Case NPV Range
Revenue (±20%) -$2.3M $14.8M $31.9M $34.2M
Initial CAPEX (±15%) $20.4M $14.8M $9.2M $11.2M
OPEX (±25%) $19.3M $14.8M $10.3M $9.0M
Discount rate (±2%) $21.6M $14.8M $9.2M $12.4M
Project life (±5 yr) $10.1M $14.8M $17.5M $7.4M

Scenario Analysis

Evaluate NPV under different complete scenarios:

Three Scenario Analysis: Base Case (50% probability): - Revenue: $8M/yr - OPEX: $2M/yr - CAPEX: $37M - NPV: $14.82M Optimistic Case (25% probability): - Revenue: $9M/yr (higher throughput) - OPEX: $1.8M/yr (efficiency gains) - CAPEX: $35M (under budget) - NPV: $28.45M Pessimistic Case (25% probability): - Revenue: $6.5M/yr (lower throughput) - OPEX: $2.3M/yr (higher costs) - CAPEX: $40M (overrun) - NPV: -$1.23M Expected NPV: E(NPV) = 0.25 × 28.45 + 0.50 × 14.82 + 0.25 × (-1.23) E(NPV) = 7.11 + 7.41 - 0.31 = $14.21M Risk: 25% chance of negative NPV in pessimistic case

Break-Even Analysis

Find value of variable that makes NPV = 0:

Break-Even Revenue: For lateral example, find revenue that gives NPV = 0: 0 = -37 + (Rev - 2) × [(1 - 1.10^-20) / 0.10] + 0.74 0 = -37 + (Rev - 2) × 8.514 + 0.74 0 = -36.26 + 8.514 × Rev - 17.03 0 = 8.514 × Rev - 53.29 Rev_breakeven = 53.29 / 8.514 = $6.26M/year Interpretation: Need at least $6.26M annual revenue for positive NPV Base case $8M is 27% above breakeven (good margin) Break-even capacity (if tariff = $2/Mcf): Q_breakeven = 6.26M / $2 = 3.13 MMcf/day

Monte Carlo Simulation

Probabilistic analysis using random sampling:

Monte Carlo NPV Simulation: Define probability distributions for key variables: - Revenue: Normal(μ=$8M, σ=$1.5M) - OPEX: Normal(μ=$2M, σ=$0.4M) - CAPEX: Triangular(min=$33M, mode=$37M, max=$42M) - Discount rate: Fixed at 10% Run 10,000 simulations: 1. Randomly sample revenue, OPEX, CAPEX from distributions 2. Calculate NPV for each draw 3. Compile NPV distribution Results (example): - Mean NPV: $14.5M - Median NPV: $14.8M - Std Dev: $8.2M - P(NPV > 0): 92% (8% risk of loss) - P(NPV > $20M): 25% - 5th percentile NPV: -$2.1M (worst case) - 95th percentile NPV: $29.3M (best case) Decision: 92% probability of positive NPV supports investment

Decision Trees for Sequential Decisions

Analyze projects with decision points over time:

Example: Two-Phase Pipeline Expansion Year 0: Decide whether to build Phase 1 ($30M) Year 3: If demand high, build Phase 2 ($40M); if low, abandon Phase 1 alone: - High demand (60% prob): NPV = $20M - Low demand (40% prob): NPV = -$5M Phase 2 (if built in Year 3 after high demand): - Additional NPV = $35M (discounted to Year 3) - PV at Year 0 = 35M / (1.10)^3 = $26.3M Decision tree: Year 0: Build Phase 1 Year 3 (if high demand): Build Phase 2 Year 3 (if low demand): Do not build Phase 2 Expected NPV: E(NPV) = 0.60 × (20 + 26.3) + 0.40 × (-5) E(NPV) = 0.60 × 46.3 + 0.40 × (-5) E(NPV) = 27.78 - 2.0 = $25.78M Option value from flexibility: $25.78M vs. $11M (Phase 1 only expected NPV)
Real options: Projects with flexibility (expand, contract, abandon, delay) have option value beyond simple NPV. Use decision trees or real options analysis (Black-Scholes for deferral option) to capture value of managerial flexibility in uncertain environments.

5. Practical Applications

Capital Budgeting - Portfolio Selection

Allocate limited capital across competing projects:

Example: $100M Capital Budget, 5 Projects Available Project A: Lateral extension - CAPEX: $37M, NPV: $14.8M, IRR: 15.1%, PI: 0.40 Project B: Compressor upgrade - CAPEX: $25M, NPV: $8.2M, IRR: 14.5%, PI: 0.33 Project C: Integrity replacement - CAPEX: $15M, NPV: $3.5M, IRR: 11.8%, PI: 0.23 Project D: Metering system - CAPEX: $8M, NPV: $4.1M, IRR: 18.2%, PI: 0.51 Project E: Greenfield pipeline - CAPEX: $65M, NPV: $22.0M, IRR: 13.2%, PI: 0.34 Ranking by NPV: 1. Project E: $22.0M 2. Project A: $14.8M 3. Project B: $8.2M 4. Project D: $4.1M 5. Project C: $3.5M Total NPV if all accepted: $52.6M Total CAPEX required: $150M (exceeds $100M budget) Solution 1: Rank by NPV (accept E, A, B, D) Total CAPEX: $135M (still exceeds budget) Solution 2: Rank by PI (value per dollar invested) 1. Project D: PI = 0.51 2. Project A: PI = 0.40 3. Project E: PI = 0.34 4. Project B: PI = 0.33 5. Project C: PI = 0.23 Accept D + A + B: CAPEX = $70M, Total NPV = $27.1M ✓ Add C: CAPEX = $85M, Total NPV = $30.6M ✓ Optimal portfolio: D, A, B, C for $85M CAPEX, $30.6M NPV Remaining $15M for smaller projects or reserve

Compressor Station Economics

Example: Add Compression for Capacity Increase Current capacity: 500 MMcf/day With compressor: 650 MMcf/day (+30%) Investment: $50M compressor station Incremental revenue: - Additional throughput: 150 MMcf/day - Tariff: $0.50/Mcf - Annual revenue increase: 150,000 × 365 × $0.50 = $27.4M/yr Incremental costs: - Fuel (natural gas): 4,500 hp × 7.5 scf/hp-hr × 8760 hr × $4/Mcf = $11.8M/yr - Maintenance: $1.2M/yr - Labor: $0.5M/yr - Total OPEX: $13.5M/yr Net cash flow: $27.4M - $13.5M = $13.9M/yr NPV at 9% WACC, 20-year life: PV annuity = 13.9 × [(1 - 1.09^-20) / 0.09] = 13.9 × 9.129 = $126.9M NPV = -50 + 126.9 = $76.9M ✓ IRR: Solve 0 = -50 + 13.9/(1+IRR)^1 + ... + 13.9/(1+IRR)^20 IRR = 27.4% (very high return) Decision: Highly attractive project, NPV = $77M, IRR = 27%

Pipeline Replacement Decision

Example: Replace vs. Repair Aging Pipeline Current situation: - 40-year-old pipeline with corrosion - Increasing leak rate, integrity concerns - Annual maintenance: $2M/yr and rising Option 1: Continue operating (do nothing) - Maintenance costs escalate: $2M yr1, $2.3M yr2, $2.6M yr3, ... - Risk of failure: 5% annual probability - Failure cost: $25M (cleanup, lost revenue, regulatory penalties) - Expected annual failure cost: 0.05 × $25M = $1.25M - Total annual cost: ~$3.5M/yr (rising) - PV of 20-year costs at 9%: $3.5M × 9.129 = $31.95M Option 2: Full replacement - New pipeline CAPEX: $60M - Annual maintenance (new): $0.5M/yr - Failure risk: 0.1% (negligible) - PV of 20-year costs: $0.5M × 9.129 = $4.56M - Total cost (PV): $60M + $4.56M = $64.56M Option 3: Partial replacement (hotspots only) - Selective replacement CAPEX: $25M - Annual maintenance: $1.2M/yr - Failure risk: 1% annual - Expected failure cost: 0.01 × $25M = $0.25M - Total annual cost: $1.45M/yr - PV: $25M + $1.45M × 9.129 = $38.24M Comparison (all costs in PV): Do nothing: $31.95M (but rising, high risk) Partial replacement: $38.24M Full replacement: $64.56M Incremental NPV (partial vs. do nothing): Cost increase: $38.24M - $31.95M = $6.29M Benefit: Reduced failure risk, regulatory compliance Decision: Partial replacement justified if compliance required Incremental NPV (full vs. partial): Cost increase: $64.56M - $38.24M = $26.32M Benefit: Very low failure risk, 40-year asset life Decision: Full replacement if long-term operation planned

Tariff Negotiation Analysis

Determine minimum acceptable tariff for pipeline project:

Required Tariff Calculation: Project: 100-mile, 24" pipeline CAPEX: $250M OPEX: $5M/year Design capacity: 500 MMcf/day Expected utilization: 70% (350 MMcf/day average) WACC: 9%, Project life: 30 years Annual throughput: 350,000 Mcf/day × 365 days = 127.75 MMcf/year Find tariff that gives NPV = 0 (break-even): 0 = -250 + (Tariff × 127.75M - 5M) × [(1-1.09^-30)/0.09] Annuity factor = 10.274 0 = -250 + (Tariff × 127.75M - 5M) × 10.274 0 = -250 + 1312.5M × Tariff - 51.4M 301.4M = 1312.5M × Tariff Tariff_breakeven = 301.4 / 1312.5 = $0.230/Mcf Add margin for acceptable return (NPV = $50M target): 50 = -250 + (Tariff × 127.75M - 5M) × 10.274 300M = 1312.5M × Tariff Tariff_target = $0.229/Mcf... Recalculate: 50 = (Tariff × 127.75M - 5M) × 10.274 - 250 300 = (Tariff × 127.75M - 5M) × 10.274 29.19 = Tariff × 127.75M - 5M Tariff_target = 34.19M / 127.75M = $0.268/Mcf Conclusion: Minimum tariff $0.23/Mcf (breakeven) Target tariff $0.27/Mcf for $50M NPV (20% return on investment)

Acquisition Valuation

Value existing pipeline asset for acquisition:

Example: Pipeline Acquisition Analysis Target: Existing gathering system Current revenue: $30M/year Current OPEX: $12M/year Remaining useful life: 15 years WACC: 10% Base case valuation (no improvements): Annual cash flow: $30M - $12M = $18M PV = 18M × [(1-1.10^-15)/0.10] = 18M × 7.606 = $136.9M Add terminal value (salvage): Salvage value = $20M at Year 15 PV = 20M / (1.10)^15 = 20M × 0.2394 = $4.8M Total value: $136.9M + $4.8M = $141.7M Post-acquisition improvements: - OPEX reduction (synergies): -$2M/year - Capacity expansion: +$5M/year revenue - Incremental cash flow: $7M/year PV of improvements: 7M × 7.606 = $53.2M Maximum acquisition price (with synergies): Value = $141.7M + $53.2M = $194.9M Less: Integration costs ($10M) and risk buffer (10%) Bid price: ($194.9M - $10M) × 0.90 = $166.4M Negotiation range: $140M - $165M

Common Pipeline NPV Applications

Application Key Considerations Typical Project Life
Greenfield transmission Large CAPEX, long-term contracts, regulatory approvals 30-50 years
Lateral/extension Incremental revenue, connection risk, anchor shippers 20-30 years
Compression addition Capacity increase, fuel costs, existing system integration 20-25 years
Pipeline replacement Avoided failure costs, regulatory compliance, salvage value 30-40 years
Metering/SCADA upgrade Labor savings, accuracy improvement, technology obsolescence 10-15 years
Acquisition Synergies, integration costs, due diligence risks 15-30 years remaining
Best practices: Always perform sensitivity analysis on key assumptions (tariff, throughput, CAPEX). Use probability-weighted scenarios for high-uncertainty projects. Include real options value for flexible projects (phased expansion, abandonment options). Conservative assumptions better than optimistic for capital approval.

Industry Standards and References

  • FERC regulations: Federal Energy Regulatory Commission tariff and rate-making guidelines for interstate pipelines
  • IRS Publication 946: MACRS depreciation for pipeline assets (15-year or 20-year property)
  • SEC guidance: Proved reserves and project valuation disclosure requirements
  • GAAP/IFRS: Accounting standards for capital investments and impairment testing
  • Project Management Institute (PMI): Economic analysis standards and best practices

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