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 $4,508 investment) which calculates to a 10% return, without prices increasing.
|Present Value of a 3 Year Annuity|
|Barrels Produced||Income/ Barrel||Income Received||Present Value @ 10%|
|1||100||$ 20||$ 2,000||$ 1,818|
|2||90||$ 20||$ 1,800||$ 1,488|
|3||80||$ 20||$ 1,600||$ 1,202|
|Total||$ 5,400||$ 4,508|