Courses

Time Value of Money

Economic Indicators

Welcome to:
Petroleum Economics

Its all about Money

To get the Money:

Make sure you are present (sign in the attendance sheet)
Listen carefully and full concentration
Do assignments and quiz
Successful in the Final Exam

WHY?

In 1980s, oil industries realize that the strategic company

decisions were made by a non petroleum background which
has little knowledge on the technical petroleum point of view.
Petroleum man just takes a role only in a Field or as an Engineer
not in the management position.
Such that, the company policies regarding petroleum
development should be treated by Petroleum man with additional
knowledge in Economic and management.
Eventually Petroleum Economics was born.

PETROLEUM ECONOMICS

TIME VALUE
OF MONEY

Dr. Ridha

Which would you

rather have -$1,000 today or
$1,000 in 5 years?

Obviously, $1,000 today.

Money received sooner
rather than later allows
one to use the funds for
investment or
consumption purposes.
This concept is referred to
as the TIME VALUE OF
MONEY!!

Why TIME?
TIME allows one the opportunity to
postpone consumption and earn INTEREST.

NOT having the opportunity to earn

interest on money is called OPPORTUNITY
COST.

How can one compare amounts in

different time periods?
One can adjust values from different time
periods using an interest rate.

One CANNOT compare numbers in different

time periods without first adjusting them
using an interest rate.

Definition
The time value of money the value of
money figuring in a given amount of interest
earned over a given amount of time.

Sooner or Later?

A productive life of petroleum project may take more than 40

years

In such circumstances, it is clearly necessary to consider how

the value of money changes over time

Under most circumstances, early receipt carries logical

benefits, including:
a.
b.
c.
d.

Investment opportunity
Purchasing power
Risk
Security and flexibility

Early receipt benefits:

a.

Investment opportunity the sooner one receive the

money, the sooner it may be invested and the sooner it may
start to grow

b.

Purchasing power money spent sooner can buy more

goods and services

c.

Risk the further into the future, the greater the

opportunity for something to fail or to be broken

d.

Security and flexibility Early access to funds reduces risk

of problems associated with cash shortage, including
bankruptcy.

Interest [ i ]

Fundamentals of time value of money

This is a cost of having money available for use
Interest is a basis for investment analysis
It is the income, which grows to the owner of money or
capital as a routine payment
Conversely, interest is the cost, which grows to one who
borrow.
There types of Interest in the cash flow
analysis:
1. Fixed Interest
2. Simple Interest
3. Compound Interest
4. Nominal Annual Interest
5. Continuous Compounding

1. Fixed Interest
Defined as a proportion of the amount invested (or borrowed) and
independent of the investment time
P
RM 1000

2.

i = fix

Fn

time

RM 1200
RM 1300

Could be

P = Present Amount [time zero]

Fn = Future Amount [after n period]
i = interest rate [per period]

Simple Interest

Defined as a constant proportion of the initial amount per period of time

Fn = P * [ 1 + ( n * i ) ]
Example:

P = RM 100
i = 12%
n = 10 years

The future value of simple interest?

Fn = 100 * [ 1 + ( 10 * 0.12 ) ]
= RM 220

3. Compound Interest
Defined as a proportion of the accumulated debt or investment. The
interest charged or paid in the current year includes a proportion of
interest incurred or awarded in previous years.

Fn = P * [ 1 + i ] n
Example:

RM 100 is invested for 10 years at 12 % interest per year, what is

the future value?

Fn = 100 * [ 1 + 0.12 ] 10
Fn = 100 * 3.106
= RM 310.6
Comparisons:
Simple interest = RM 220
Compound interest = RM 310.6

Different growth

Comparison of Simple and Compound Interest @ 12%

4.

Nominal Annual Interest

An interest rate is called nominal if the frequency of compounding
(e.g. a month) is not identical to the basic time unit (normally a year).
By that, two further definitions of interest can be recognized:
Period interest the proportional interest which is added after each
compounding period
Nominal interest the period interest times the number of periods
in a year.
Let

j = Nominal interest, p = Compounding periods per year

j/p = Period interest

Fn = P * [ 1 + (j/p) ] p*n
Example:

RM 100 is invested for 10 years at 12 % nominal interest per year,

with monthly compounding. What is the future value?

Fn = P * [ 1 + (0.12/12) ] 12*10
Fn = 100 * [1.01] 120
= RM 330

5.

Continuous Compounding

Defined as a compounding scheme based on infinite number of compounding

periods in the year.

Fn = P * e j*n
Example:
RM 100 is invested for 10 years at 12 % nominal interest, with
compounding first per year then 12 and 365 times per year.
For continuous compounding, the number of compounding
periods becomes infinitely large.

Fn = P * e j*n
= 100 * [ e ] 0.12 * 10
= 100 * 3.320
= RM 332

Short Exercises
1. You deposit RM 345 into a bank account paying 7% simple
interest per year. How much interest would you earn after
5 years?

Its all about Money

Simple Interest

2. You take out a loan of RM 800 and the bank charges you
15% compound interest per year. If you don't pay off any
of the loan in 4 years, how much would you owe the bank?

Compound Interest

3. How much money would you need to deposit today at 9%

annual interest compounded monthly to have RM 12000 in
the account after 6 years?

Nominal Annual
Interest

4. What will the future value if RM 200 is invested for 10

years at 12 % nominal interest, with compounding first per
year then 12 and 365 times per year?

Continuous
Compounding

Solutions
1. P = RM 345, i = 7% (0.07), n = 5 years, F = ???

Fn = P * [ 1 + ( n * i ) ]
F = 345 * [ 1+(5*0.07)]
F = 345 * 1.35
F = 465.75
So the interest earned after 5 years which
will be (465.75 345) = RM120.75
2. This time we are dealing with compound interest so the interest
earned gets added to the original amount each year.

Fn = P * [ 1 + i ] n
P = RM800, i = 15% (0.15), n = 4 years, F = ???
F = 800 * [1 + 0.15]4
F = 800 * 1.749
F = 1399.2 (you owe the bank)

3. Define a Present value?., with monthly compounded for 6 years.

We use Nominal Annual Interest
Fn = P * [ 1 + (j/p) ] p*n
P = RM 12000, I = 9% (0.009), p = 12 months, n = 6 years
12000 = P * [ 1 + (0.09/12) ] 12*6

12000= P * [ 1.7125527]
P = 7007.08 [RM]

4. Define a Future value?...., with compounding first per year then 12

and 365 times per year Continuous Compounding
Fn = P * e j*n
P = RM 200, j = 12% (0.12), n = contunious
F = 200 * [ e ] 0.12 * 10
F = 200 * 3.320
F = RM 664

Compounding Interest Compounding

Define as : The ability of an asset to
generate earnings, from previous
earnings.

The process of determining the

future value of a payment

Application of Compounding
a.

Compute terminal value of a single investment.

b. Time shifting of cash flows for addition and

comparison.
c.

Prices escalations.

d. Ranking of investments on basis of terminal

values.

a. Terminal Value
Defined as the present value to future point in time
Recall:

Fn = P * [ 1 + i ] n

[compounding equation]

It enables the terminal value (Fn) to be calculated when the initial

amount (P), the rate of interest (i), and the investment period (n) are
known.
Example:
If RM 100 is invested for 10 years at 12% interest per year, what is the terminal
value at year 10.

P = RM 100, i = 0.12, n = 10 years

F10 = P * [ 1 + i ] n
= 100 * [1 + 0.12 ]10
= 100 * 3.106
= RM 310.6 [terminal value]

b. Time Shifting of Cash Flows

Cash flows associated with an investment commonly occur at different

points in time
In order to compare these cash flows at different points in time, the cash
flows must be brought to a common point in time.
1. Cumulative method
CashFlow [C] is compounded forwarded by one time step

{ C4 + C3 [ 1 + i ] + C2 [ 1 + i ]2 + C1 [ 1 + i ]3 }
In general form:

Cn + Cn-1 [ 1 + i ] + . . . + C2 [ 1 + i ]n-2 + C1 [ 1 + i ]n-1

2. Direct method
Each CashFlow [C] is taken separately and is compounded
directly forward to an appropriate time period

C1 = C 1 * [ 1 + I ] 3
C2 = C2 * [ 1 + I ] 2
C3 = C 3 * [ 1 + I ] 1
C4 = C 4
[time shift]

c. Price Escalations

Supply

Inflation
Interest rate

Demand
Price projection as a
function of time and
interest rate

Compound factor

Note:
1 US gallon = 3.78 Liter

d. Ranking of Investments

By Compounding
Applied as a basis for comparing investment opportunities.
Compare terminal values at the same point in time.

Rank the values.

Case study.

Option 2

(3)
(2)
(1)

Discounting Interest Discounting

The process of determining the present value of a
payment.
Mathematically, discounting is the inverse of
compounding.
Recall, compounding equation:

F = P * (1 + i ]n

Then,
Discounting equation would be:

P = F * (1 + i ]-n

F = future value
P = present value
i
= interest
(1+i)n = compound factor
(1+i)-n = discount factor

Application of Discounting
a. Computation of present value of a single future
cash flow.
b. Computation of present value of a series of
future cash flows.
c. Ranking of investments on the basis of present
value.
d. Comparison of production profiles.

a. Present value of a single future cash flow

Recall

P = F * (1 + i ]-n

Discounting equation

b. Present value of a series of future cash flows

a. Cumulative method

b. Direct method
Each cash flow is taken separately and
discounted directly backward in time

C1 = C 1
C2 = C2 * [ 1 + I ] -1
C3 = C3 * [ 1 + I ] -2
C4 = C4 * [ 1 + I ] -3

c. Ranking of investments

By Discounting
Present value can be computed for any cash flows.
It has intrinsic an advantage over compounding for
ranking of investments.
The time origin is similar with other project compared to
that of compounding.

Case study.

Similar data
as it used for
Terminal
Value

Option 1:

1250 is placed on deposit for 10 years at 5%.

Regardless of when this investment is withdrawn, it will have a
discounted of present value of 1250.

Option 3:

The direct payment of 3500 would be received after 10 years.

The present value is derived by discounting at 5% over 10
years:
P = 3500 * [1 + 0.05)-10
P = 3500 * 0.614
P = 2148.7

Option 2:

This is more complex calculation as the investment returns 10

years payments of 250, each of which must be discounted
back to the present value by the appropriate number of years.

Case 2

(3)
(2)
(1)

Another Issues..?
How if we change the Interest Rate? Lets say we change to 12%

Rank by Present value @ variation of Interest rate

d. Comparison of Production Profiles

Why decline?
3 reasons..

* Discount rate
* Reservoir pressure
* Taxation
[oil price]

Example of
HUTTON Field
in North Sea

ANNUITY
Annuity is a series of payments made at fixed intervals of time

The present value of an annuity is the value of a stream of payments,

discounted by the interest rate to account for the fact that payments are
being made at various moments in the future.
(Annuity equation)

P
A
I
N

= Present value of annuity

= present value for payment
= discount rate
= number of cash flow

Example:
During years one and two, a company is spending RM 5000
each year on a new oil field. The company expects to save
(positive cash flow) RM 8000 each year for years 3, 4, 5, & 6. Is
the project worthy of consideration if the company expects a
15% interest on its investments?

Solution:
The following are the cash flows:
1

-RM5000

15%
3

-RM5000

RM8000

RM8000

RM8000 RM8000

Present Value Calculation

PV of -RM5000 Annuity, 2 years, 15% = 1.62571 x -RM5000

= -RM8128.54

PV of RM8000 Annuity, 4 years, 15% = 2.85498 x RM8000

= RM22839.84
(The RM22839.84 is lands at the end of year 2 and must be treated as a lump sum)
PV of RM22839.84, end of year 2, 15% = 0.75614 x RM22839.84

Add up the results inside the boxes for the final total

= RM17270.12

= RM9141.57

Since the end result is positive (greater than zero) the project passes the NPV test
and might be worthy of further consideration.

THANK YOU