ENCH 687 | ENPE 626

Petroleum Economics
Fall 2018 | Dr. Roman J Shor
Time Value of Money
• Present Value
• Time Value of Money
• Compounding
• Discounting

• Inflation
• Discount Rates
• Nominal and Real Rates

(c) Roman J. Shor, University of Calgary Sept 19, 2018 2

What is interest?
• Interest is the cost necessary to borrow money or the revenue from lending money. The
interest rate is determined from:
• The prime lending rate is the interest rate charged by banks to customers with prime (best)
credit. It is a function of
• The discount rate, the rate the central bank charges banks to borrow from it, and
• The federal funds rate, the target rate for banks to borrow amongst each other

• Interest rates may be higher than the prime lending rate, and this may be due to:
• Lender’s risk
• Length of the loan
• Smaller loan amounts
• Less competitive financial system
• Nature of the investment

• Changes in interest rates are reported in basis points

• i.e. 50 basis points = 0.5% change

(c) Roman J. Shor, University of Calgary Sept 19, 2018 3

Simple and Compound Interest
• Simple interest is calculated from the principle only

!"#$%$&# = (%)"*)+,- × /012$% 34 ($%)35& ×(!"#$%$&# 7,#$ +$% ($%)35)

• Example: $2000 is borrowed at 8% interest per year.

• What is the repayment at the end of one year?

• What is the repayment if repaid after 90 days?

(c) Roman J. Shor, University of Calgary Sept 19, 2018 4

Simple and Compound Interest
• Simple interest is calculated from the principle only

!"#$%$&# = (%)"*)+,- × /012$% 34 ($%)35& ×(!"#$%$&# 7,#$ +$% ($%)35)

• Example: $2000 is borrowed at 8% interest per year.

• What is the repayment at the end of one year?

(%)"*)+-$ + !"#$%$&# = $2000× 1 + 0.08 = $2160

• What is the repayment if repaid after 90 days?

(c) Roman J. Shor, University of Calgary Sept 19, 2018 5

Simple and Compound Interest
• Simple interest is calculated from the principle only

!"#$%$&# = (%)"*)+,- × /012$% 34 ($%)35& ×(!"#$%$&# 7,#$ +$% ($%)35)

• Example: $2000 is borrowed at 8% interest per year.

• What is the repayment at the end of one year?

(%)"*)+-$ + !"#$%$&# = $2000× 1 + 0.08 = $2160

• What is the repayment if repaid after 90 days?

90
(%)"*)+-$ + !"#$%&# = $2000× 1 + 0.08× = $2040
360

(c) Roman J. Shor, University of Calgary Sept 19, 2018 6

Simple and Compound Interest
• Compound Interest is calculated base on the principal plus any unpaid interest accrued
in previous periods, known as compounding periods.
• In this case, interest is calculated using
-.
*+
!"#$%$&# = 1+ − 1 ×1%*"2*345
,
• Or
-.
*+
1%*"2*345 + !"#$%$&# = 1 + ×1%*"2*345
,
• Where *+ is the nominal interest rate per year, , is the number of compounding periods
(i.e., , = 1 for annual compounding, , = 12 for monthly compounding, etc) and # is the
time in years

(c) Roman J. Shor, University of Calgary Sept 19, 2018 7

Simple and Compound Interest
• Example: $2000 is borrowed for one year at 8% per year.
• Annual compounding:

• Quarterly compounding:

• What is the interest paid each quarter?

• Semiannual compounding, but for 3 years

(c) Roman J. Shor, University of Calgary Sept 19, 2018 8

Simple and Compound Interest
• Example: $2000 is borrowed for one year at 8% per year.
• Annual compounding:
-×-
0.08
!"#$%$&# = 1+ − 1 ×$2000 = $160
1
• Quarterly compounding:
-×4
0.08
!"#$%$&# = 1+ − 1 ×$2000 = $164.86
4
• What is the interest paid each quarter?
0.08
516789:9;8 = ×$2000 = $40
4
0.08
526789:9;8 = × $2000 + $40 = $40.80
4
0.08
536789:9;8 =
× $2000 + $40 + $40.80 = $41.62
4
• Semiannual compounding, but for 3 years
0.08 =×>
!"#$%$&# = 1 + − 1 ×$2000 = $530.64
2

(c) Roman J. Shor, University of Calgary Sept 19, 2018 9

Interest Rates and Compounding
• If you save $10 today, and if interest
is compounded monthly, it will be
worth:
• $21.13 if the interest rate is 5%
• $44.43 if the interest rate is 10%
• $93.56 if the interest rate is 15%
• $195.95 if the interest rate is 20%

(c) Roman J. Shor, University of Calgary Sept 19, 2018 10

Nominal vs Effective Interest Rate
• The Nominal Interest Rate, !" , is the interest rate is the rate before compounding (i.e. the
8% in the previous examples)

• The Effective Interest Rate, !# , is the interest rate that if it was only compounded
annually.
!" (
!# = 1 + −1
'
where ' is the number of compounding periods per year.

• Example: a nominal interest rate of 8% compounded quarterly is:

.
0.08
!# = 1 + − 1 = 0.08243 = 8.243%
4

(c) Roman J. Shor, University of Calgary Sept 19, 2018 11

Cash Flow 40

30
• A typical project will have:
20
• Cash Receipts – inward flow of cash
10
• Cash Disbursements – outward flow of cash
0

Dollars
-3 -2 -1 1 2 3 4 5 6
-10
• So, Net Cash Flow is -20
!"# $%&ℎ ()*+ = -"."/0#& − 2/&345&"6"7#&
-30

-40

-50
Years

Abandoment Cost
Salvage Value
Gross Revenue
Operating Cost (OPEX)
Capital Expenditure (CAPEX)

(c) Roman J. Shor, University of Calgary Sept 19, 2018 12

Time Value of Money
• Money received today has a different value that money received tomorrow. Why?
• Risk – will you get the money tomorrow?
• Uncertainty – maybe the money tomorrow will be worth less?

• This leads to a risk preference – are you risk averse or a risk seeker?

• We can quantify this as a discount rate. How much less do you value money in the future.
This is a mirror of an interest rate.

(c) Roman J. Shor, University of Calgary Sept 19, 2018 13

Discounted Value of Future Money
• If you were to receive $10 in 15 years,
the present value of that money
would be (assuming monthly
compounding):
• $4.73 if the interest rate is 5%
• $2.24 if the interest rate is 10%
• $1.07 if the interest rate is 15%
• $0.51 if the interest rate is 20%

(c) Roman J. Shor, University of Calgary Sept 19, 2018 14

Present value of a future payment
• The Present Value of a future payment is given by

1
!" = $" )
1 + '(
where !" is present value, $" is future value and '( is the effective interest rate
• If there are periodic cash flows (i.e., you get an annual payment), then
1 1 1
!" = $" * + $" + + ⋯ + $" )
1 + '( * 1 + '( + 1 + '( )

or
/
1
!" = - $" ) )
1 + '(
).*

(c) Roman J. Shor, University of Calgary Sept 19, 2018 15

Present value of a future payment
• Example: a landowner is to receive royalty payments of $2000, $2200, $1900, $2500 and
$1500 over the next five years. The current interest (discount) rate is 8%. What is the
present value of these payments?

(c) Roman J. Shor, University of Calgary Sept 19, 2018 16

Present value of a future payment
• Example: a landowner is to receive royalty payments of $2000, $2200, $1900, $2500 and
$1500 over the next five years. The current interest (discount) rate is 8%. What is the
present value of these payments?
1 1 1
!" = $2000 + $2200 + $1900
1 + 0.08 + 1 + 0.08 , 1 + 0.08 .
+ +
+$2500 + $1500
+01.12 3 +01.12 4

!" = $1851.85 + $1886.15 + $1508.28 + $1837.57 + $1020.87 = $8104.72

(c) Roman J. Shor, University of Calgary Sept 19, 2018 17

Present value of a future payment
• Example: a landowner is to receive royalty payments of $2000, $2200, $1900, $2500 and
$1500 over the next five years. The current interest (discount) rate is 8%. What is the
present value of these payments?
This can also be solved as a Cash Flow Diagram

$2000 $2200 $1900 $2500 $1500

0 1 2 3 4 5

$1851.80 = 2000 x 0.9259

$1885.06 = 2200 x 0.8573
$1508.22 = 1900 x 0.7938
$1837.50 = 2500 x 0.7350
$1020.90 = 1500 x 0.6806

$8104.48 @ 8%

(c) Roman J. Shor, University of Calgary Sept 19, 2018 18

Interest Rate Tables (F/P) is the future value factor
(P/F) is the present value factor
• Posted on D2L

(c) Roman J. Shor, University of Calgary Sept 19, 2018 19

Future value of a present sum
• For cash currently in hand, the future value of a single payment of the amount can be
determined using
!" = $" 1 + '( )
where 1 + '( ) is known as the single payment compound amount factor

• For periodic payments,

!" = $" 1 + '( )+* + $" 1 + '( )+, + ⋯ + $" 1 + '( )+.
* , .

Or
.+*
!" = / $" 1 + '( )
)
)0*

where 1 is the number of periods (in years) and $" ) is the present value at time 2

(c) Roman J. Shor, University of Calgary Sept 19, 2018 20

Future value of a present sum
• Example: What is the future value of $3150.85 invested for 6 years at 8% interest?

(c) Roman J. Shor, University of Calgary Sept 19, 2018 21

Future value of a present sum
• Example: What is the future value of $3150.85 invested for 6 years at 8% interest?

!" = $3150.85 1 + 0.08 ) = $5000

#$%%,($)

$3150.85

0 1 2 3 4 5 6

$5000.00
@ 8%

(c) Roman J. Shor, University of Calgary Sept 19, 2018 22

Present value of an annuity
• An annuity is an equal, periodic payment or disbursement done at regular periods when
the interest is compounded at a certain rate. Examples include
• Mortgage payments
• Car loans
• Salaries and benefits payments
• Insurance premiums
• Any other installment loans

• The present value of an annuity is known as:

• An ordinary annuity if calculated one period before the first payment, or
• An annuity due if calculated on the date the first payment is received.

(c) Roman J. Shor, University of Calgary Sept 19, 2018 23

Annuities
• For something to be an annuity, it must:
• Have periodic payments or disbursements of equal amount
• The interest rate must be constant for the life of the annuity
• The time intervals must be of equal length
• The interest rate is compounded at the end of each time period

• The present value is then computed using

1 + '( ) − 1
!" = $"
'( 1 + '( )
where $" is the payment amount, and the quantity in brackets is known as the !/$
factor

(c) Roman J. Shor, University of Calgary Sept 19, 2018 24

Annuities
• Example: an oil company has to pay $10,000 per year on a loan with an effective interest
rate of 8%. What is the present value of the loan?

(c) Roman J. Shor, University of Calgary Sept 19, 2018 25

Annuities
• Example: an oil company has to pay $10,000 per year for five years on a loan with an
effective interest rate of 8%. What is the present value of the loan?
'().)+ , -'
!" = $10000 = $10000 3.9927 = $39927
).)+ '().)+ ,

$10000 $10000 $10000 $10000 $10000

0 1 2 3 4 5

$9259 = 10000 x 0.9259

$8573 = 10000 x 0.8573
$7938 = 10000 x 0.7938
$7350 = 10000 x 0.7350
$6806 = 10000 x 0.6806

$39926 @ 8%

(c) Roman J. Shor, University of Calgary Sept 19, 2018 26

Future value of an annuity
• The future value of an annuity is similarly calculated using
1 + '( ) − 1
!" = $"
'(

where the quantity in brackets is referred to as the equal payment compound amount
factor or the F/A factor
• If the calculation is done after the last payment has been made, it is called an ordinary
annuity.
• If the calculation is done at the end of the period when the final payment is made, it is
called an annuity due.

(c) Roman J. Shor, University of Calgary Sept 19, 2018 27

Present value of a deferred annuity
• If the payments for an annuity do not start at year one, then it is called a deferred annuity.
Three methods of calculation:
1 + ' ( )* − 1 1
!" = $" ×
' ( 1 + ' ( )* 1 + '( )-

1 + ' ( )* − 1 1
!" = $" ×
'( 1 + '( ()*/)-)

1 + '( )*/)- − 1 1 + ' ( )- − 1

!" = $" −
'( 1 + '( ) * /) - ' ( 1 + ' ( )-

Where 12 is the total number of years the annuity is paid and 13 is the number of year the annuity
is deferred.

(c) Roman J. Shor, University of Calgary Sept 19, 2018 28

Present value of a deferred annuity
• Example: an annuity is to be paid at $10,000 per year for years 4 through 8 with an
interest rate of 8%. Was the present value?

(c) Roman J. Shor, University of Calgary Sept 19, 2018 29

Present value of a deferred annuity
• Example: an annuity is to be paid at $10,000 per year for years 4 through 8 with an
interest rate of 8%. Was the present value?

1 + 0.08 * − 1 1
!" = $10000 × = $31,695
0.08 1 + 0.08 * 1 + 0.08 -

(c) Roman J. Shor, University of Calgary Sept 19, 2018 30

Other annuity calculations
• Annuity from present value
%& 1 + %& )
!" = $"
1 + %& ) − 1

• Annuity from future value

%&
!" = +"
1 + %& ) − 1

(c) Roman J. Shor, University of Calgary Sept 19, 2018 31

Present value from uniform gradient series
• If an annuity declines at a constant rate, !, then the present value can also be calculated.
This is useful in cases such as declining production rates from oil wells.

1 +
"# = "% ± ! − -
() 1 + () −1
where ! is the annual change and "% is the cash flow at the end of year one.

(c) Roman J. Shor, University of Calgary Sept 19, 2018 32

Present value from uniform gradient series
• Example: an oil well produces 2000 barrels of oil per year in the first year, and then
declines by 200 barrels per year for the next five years. Interest rate is 8% and oil is $75
per barrel. What is the present value of the well?

(c) Roman J. Shor, University of Calgary Sept 19, 2018 33

Present value from uniform gradient series
• Example: an oil well produces 2000 barrels of oil per year in the first year, and then
declines by 200 barrels per year for the next five years. Interest rate is 8% and oil is $75
per barrel. What is the present value of the well?

1 6
!" = 2000 ± 200 − = 1544.74 112/4567
0.08 1 + 0.08 - − 1
!" = 1544.74×$75 = 115,855.50

;
;" = $115,855.50× = $115,855.50×4.6229 = $535,588.39
! <=>%,@=-

(c) Roman J. Shor, University of Calgary Sept 19, 2018 34

Continuous Interest Compounding
Factor Continuous Interest Continuous Interest
Discrete Cash Flow Continuous Cash Flow
Single payment F/P !" = $" % &' (% &'
compound amount !" = $"
%& − 1
factor
Uniform series F/A % &' − 1 % &' − 1
compound amount !" = +" !" = +"
%& − 1 (
factor
Capital recovery factor A/P % & − 1 % &' (% &'
+" = $" +" = $"
% &' − 1 % &' − 1

(c) Roman J. Shor, University of Calgary Sept 19, 2018 35

Time Zero Dilemma
• When is time zero?

• For cash flow that occurs during the first year, when should it be counted?
• January 1st?
• June 30th?
• December 31st?

• Depend on when this is counted, the Net Present Value (NPV) may differ by as much as
10%!

(c) Roman J. Shor, University of Calgary Sept 19, 2018 36