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(1)Definition. A widely used method for deriving a pre-tax base discount rate for valuation purposes is the band of investment, or WACC technique. The basis for this analysis is the financial data from a broad sample of oil companies that derive a majority of their operating revenues from oil and gas production. Since petroleum property valuation typically involves discounting cash flows over a long period of time, a long-term cost of capital is most appropriate for developing an oil or gas property discount rate. Thus, the appraiser should incorporate a broad time series of data to approximate a long-term cost of capital. (2)Required calculations. Four sets of calculations are required to determine the WACC. (A)The typical capital structure is derived and expressed as a proportion of debt and equity. (B)The typical cost of outstanding debt is calculated based on bond yields. (C)The typical cost of equity is computed using the Capital Asset Pricing Model (CAPM) or another method such as the DCF Model. (D)Debt and equity costs are weighted according to the typical capital structure percentages and added to derive a typical cost of capital. (3)Capital structure. (A)"Capital structure" describes in percentage terms the sources of funds (capital) used to purchase the assets necessary to operate a company. The capital structure of any company consists of debt and equity. The debt portion consists of long-term debt (represented by outstanding bonds) and preferred stock, while the equity portion consists of outstanding common stock. If the company is funded by debt and equity of equal value, the capital structure is 50% debt and 50% equity. (B)To estimate a discount rate for mass-appraisal purposes, the appraiser should use the typical market capital structure for a representative group of major and independent oil companies that derive a majority of their operating revenues from oil and gas production. (4)Cost of debt. The yield-to-maturity is the best approximation of the cost of debt capital. This yield is observable in the marketplace and can be found by referring to Standard and Poor's Corporation Bond Guide, Moody's Bond Report, or a comparable publication. (5)Cost of equity. (A)The CAPM is the preferred approximation of equity cost since it considers both historical market yields and current expectations, plus a market-derived equity risk factor. The CAPM method measures the cost of equity by considering that an investor's required rate of return on common stock is comprised of a risk-free return plus a risk-adjustment factor related to the specific stock. This is represented by the following equation: K = Rfc + B(Rm - Rfh) where: K = cost of equity (after tax), %/year; Rfc = current risk-free rate, %/year; Rm = historic market return on equities, %/year; Rfh = historic market return on long-term government bonds, %/year; B = BETA coefficient. (B)The current risk-free rate (Rfc) is typically based on current long-term government securities, i.e., the yield-to-maturity observed on an annual basis on a default-free treasury bond, note, or bill of the relevant time period. For oil and gas property appraisal, the yield on a long-term bond is an appropriate measure of the risk-free rate. (C)The historical market return on equities (Rm) on common stocks and the historical arithmetic mean on long-term government bond income returns (Rfh) can be obtained from Ibbotson Associates' Stock, Bonds, Bills and Inflation. The beta coefficient (B) measures market risk by regressing the stock's total return against the market's total return. A more detailed description of the beta calculation can be found in the Ibbotson Associates report. The beta coefficient value can be obtained from Value Line Publishing, Incorporated's The Value Line Investment Survey, Standard and Poor's Corporation's S&P Stock Reports and similar investment services. (D)The difference between the historical risk-free (Rfh) and market (Rm) rates of return is a measure of the non-systematic or non-market related risk caused by changes specific to the companies comprising the stock rate of return sample and is, in effect, an equity risk premium. Note that two different risk-free rates of return are used in the CAPM. The current risk-free rate (Rfc) is used to acknowledge the expectational function of the model. The historical risk-free rate (Rfh) is used in conjunction with the historical market return for the same time period when calculating the equity risk premium. (E)The cost of equity resulting from this model is a nominal (current dollar) after tax rate. Conversion to a nominal, pre-tax rate requires dividing the equity cost (K) by one minus the federal statutory income tax rate for petroleum companies. The income tax rate is presently 35%. This is represented by the following equation: K(pre-tax) = K/(1 - .35). If the appraiser calculates a typical effective income tax rate from a representative sample of petroleum companies that could participate in the market for the property that he or she is appraising, the appraiser may substitute that typical effective income tax rate for the statutory rate. (6)Weighting debt and equity costs. (A)Once capital structure, debt, and equity costs are determined, the final step in deriving the WACC is to weight the cost of debt and equity by the proportional share each has in the overall capital structure. This is represented by the following equations. Figure: 34 TAC §9.4031(j)(6)(A) (No change.) (B)The WACC estimating technique is illustrated in subsection (m) [(k)(3)] of this section (Appendix 2). (7)Final discount rate selection. (A)As discussed earlier, the typical WACC of potential purchasers sets the lower end of the discount rate range. To help establish the upper end of the discount rate range, the appraiser can calculate a standard deviation of all the discount rates indicated by the sales in the sales sample and the survey. One standard deviation above and below the mean contains 68% of all the observations in a normally distributed set of data. Two standard deviations above and below the mean contains over 99% of all the observations in a normally distributed set of data. The data may not be normally distributed. Even so, this kind of analysis may help the appraiser to establish the upper end of the discount rate range. (B)Very high-risk properties (for example, a one-well lease with high water production near the end of its economic life) may be discounted by the market at two standard deviations above the mean. Properties with lesser risk will have correspondingly lower discount rates. One standard deviation above the mean may establish an upper limit for properties in a typical risk-range. The mean or median of the discount rates from the sales analysis and the survey indicates the mid-range discount rate. (C)For a standard deviation analysis to have meaning in selecting an upper limit to the discount rate range, the survey or sales data set must contain properties with broadly varying risk. A high-end discount rate selected by this method will not apply to very risky properties (it will be too low) unless these risky properties are represented in the sales data set used in the analysis. (D)To select a discount rate for an individual property, the appraiser must assess the property-specific risk inherent in the property. Subsection (o) [(k)(3)] of this section (Appendix 4) lists risk factors that should be taken into account. (k)Summary. (1)This manual describes methods and procedures used to calculate the present value of oil and gas properties using discounted future income. The discounted cash flow method, DCF, is the most widely used method to appraise mineral properties. (2)Within the DCF equation, there are three generally accepted techniques for estimating a discount rate: market surveys, oil and gas sales analysis and the weighted average cost of capital. Ideally, the appraiser should use these three techniques simultaneously to develop a range of discount rates. (3)The evaluation of oil and gas properties demonstrates the importance of viewing a discount rate in the context of the entire appraisal, including the production decline rate, price, and cost parameters. The discount rate should not be considered an isolated variable, for it is only one component of a complex interaction of variables that collectively determine an estimate of value. [Figure: 34 TAC §9.4031(k)(3)] (l)Appendix 1. Attached Graphic (m)Appendix 2. Attached Graphic (n)Appendix 3. Attached Graphic (o)Appendix 4. Attached Graphic (p)Appendix 5. Attached Graphic
This agency hereby certifies that the
proposal has
been reviewed by legal counsel and found to be within the agency's
legal authority to adopt.
Filed with the Office
of the Secretary of State on August 29, 2011
TRD-201103492 Ashley Harden
General Counsel
Comptroller of Public Accounts
Earliest possible date of adoption: October 9, 2011
For further information, please call: (512) 475-0387
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