Small company economics–net present value versus net cash flow

Abstract

This paper is primarily written for the benefit of the small company that survives hand-to-mouth on a day-to-day basis. Personnel working in large profitable oil companies that spin off lots of positive cash flow may have difficulty empathising with the example.

Net present value is a commonly accepted method of project valuation. Globally, projects are valued, ranked, justified, bought and sold using this technique.

For all companies, however, cash is considered to be king. Cash funds exploration activities and corporate costs and allows companies to continue trading without returning to shareholders for additional funds. Both the solvency of the company and the dilution of share value are extremely important considerations for company directors.

For a small company with income being generated from a single small field, an example is presented where a simple decision is considered: keep the field and live off the annual income or sell the field and live off the declining balance.

This is an extremely simple example used to demonstrate the power of cash flow. No alternative investment is available and no exploration success from continued exploration drilling is experienced–the directors are only focused on funding the company’s ongoing obligations.

The conclusion from the analysis is that cash flow from a project may be preferred over selling a project for net present value and then funding the company’s obligations from the proceeds of the sale and declining funds balance.

The ultimate lesson for companies is that cash flow, however insignificant, can greatly increase their chances of long-term survival.