Investment cost estimates and investment decisions

When evaluating new investment projects, oil companies traditionally use the discounted cash flow method, which necessitates expected cash flows in the numerator and a risk-adjusted required rate of return in the denominator to calculate net present value. A significant component of this method is the capital expenditure (CAPEX) of a project, which is often represented by a single cost figure that may include an indication of its probability distribution. This article highlights the prevalent industry practice of reporting a 50/50 (median) CAPEX rather than the estimated expected (expected value) CAPEX, particularly when cost distributions exhibit asymmetry. We demonstrate that this practice can result in valuation errors, leading to potentially erroneous investment decisions and the acceptance of projects with negative net present values. The implications of relying on median CAPEX estimations in the context of investment decision-making in the oil industry and others are discussed, emphasizing the need for more accurate cost estimation methodologies to avoid significant financial risks.