# Time Value of Money

Financial theory is based on the assumption that money has “time value”; that a dollar in hand today is worth more than a dollar received in the future. For example, if you have a dollar today and use it to buy a CD paying 2%, the CD will be worth \$1.02 in a year. Stated conversely, the present value of \$1.02 to be received a year in the future is worth \$1.00 today if the interest rate (the “discount rate”) is 2%.

The concept of a discount rate is used to value the projected future income from producing properties. The discount rate is the expected rate of return. A buyer calculates the expected yield into the price they are willing to pay for a producing property.

In the following example, I have assumed our target return (a discount rate) of 10%. If we expect to receive \$5,400 in income over the next three years, we are willing to pay \$4,508 for the property. We would earn \$892 in profit (\$5,400 of income on a \$4,508 investment) which calculates to a 10% return, without prices increasing.

 Present Value of a 3 Year Annuity Year Barrels Produced Income/ Barrel Income Received Present Value @ 10% 1 100 \$         20 \$    2,000 \$    1,818 2 90 \$         20 \$    1,800 \$    1,488 3 80 \$         20 \$    1,600 \$    1,202 Total \$   5,400 \$   4,508