Skip to content
Quick Start for:
Discounting Oil and Gas Income
    Basis of the Manual
    Introduction
    Discounting
    Discounted Cash Flow Appraisal
    Discount Rate Components
    Using the Three Techniques
    Market Surveys
    Developing a Discount Rate From Sales
    Weighted Average Cost of Capital
Summary
Appendix 1: Discounted Cash Flow Method (Working Interest Portion Only)
Appendix 2: Estimation of Weighted Average Cost of Capital (WACC)
Appendix 3: Standard Deviation
Appendix 4: Property Specific Risk Factors
References
Appendix 2
Estimation of Weighted Average Cost of Capital (WACC)
  1. Derive the typical capital structure of a broad sample of potential purchasers as a proportion of debt and equity.

    Data can be found in the 12/31/19xx issue of The Value Line Investment Survey under the headings "Petroleum (Integrated) Industry" and "Petroleum (Producing) Industry."

    Outstanding Common Stock (Oil Company)
        = 157,627,284 shares @ 12/31/xx

    Closing Common Stock Price
        = $106.75/share

    Common Stock Equity
        = (157,627,284 shares) x ($106.75/share)
        = $16,827,000,000 @ 12/31/xx

    Total Debt
        = $6,791,000,000 @ 12/31/xx

    Total Capital
        = Debt + Equity
        = $6,791,000,000 + $16,827,000,000
        = $23,618,000,000

    Debt
        = $6,791,000,000/$23,618,000,000
        = .288 or 28.8%

    Equity
        = $16,827,000,000/$23,618,000,000
        = .712 or 71.2%

    The capital structure is 28.8% debt and 71.2% equity.

    Repeat this procedure for each company in the sample.

  2. Calculate the cost of outstanding debt

    Data can be found using Standard & Poor's Bond Guide (12/19xx issue)

    YTM = Yield-to-Maturity @ 12/31/19xx

    Debt
    Instrument    		 Debt
    (MM$)         		YTM
    (%/yr)    		 Debt x YTM
    Debt A $ 27 6.29 $ 170
    Debt B 586 8.42 4,934
    Debt C 132 7.52 993
    Debt D 600 7.84 4,704
    Debt E 265 4.95 1,312
    Debt F 100 8.65 865
    Debt G 300 7.87 2,361
    Debt H 450 8.28 3,726
    Debt I 123 8.70 1,070
    Debt J 224 8.78 1,967
    Debt K 300 8.29 2,487
    Debt L 500 8.38 4,190
      $ 3,607   $ 28,779

    Sum of Debt
        = Debt (MM$) x YTM
        = $28,779 MM

    Cost of Debt
        = Sum of Debt (MM$) / Debt (MM$)
        = ($28,779 MM) / ($3,607 MM)
        = 7.98 %/year

    Repeat this procedure for each company in the sample.

  3. Calculate the cost of equity

    Use the Capital Asset Pricing Model (CAPM) equation:

            K = Rfc + B(Rm - Rfh)

    where:

    K = cost of equity (after tax), %/year
    Rfc = current risk-free rate, %/yr, can be found in the Federal Reserve Statistical Release (January of current year)
    Rfh = historic market return on long-term government bonds, %/year, can be found in Ibbotson & Associates: Stocks, Bonds, Bills and Inflation
    Rm = historic market return on equities, %/year, can be found in Ibbotson & Associates: Stocks, Bonds, Bills and Inflation
    B = beta coefficient, can be found in The Value Line Investment Survey, 4th Qtr, 19xx
    Given:
    Rfc = 5.1%/year
    Rfh = 5.5%/year
    Rm = 12.4%/year
    B = .80
    K = Rfc + B(Rm - Rfh)
      = 5.1 + .8(12.4-5.5)
      = 10.6 %/year
    K (pre-tax) = 10.6/(1 - .34)
    Cost of equity = 16.1 %/year

    Repeat this procedure for each company in the sample.

  4. Calculate a typical weighted average cost of capital by plugging the mean (or other measure of central tendency) cost of debt, cost of equity and capital structure from the sample companies into the following formula:

    WACC = ((cost of debt) x (% debt)) + ((cost of equity) x (% equity))
      = (7.98 x .288) + (16.1 x .712)
      = 13.8 %/year