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

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