1669 words - 7 pages

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ASSIGNMENT

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COURSE: HAME507-01 Sep 17, 2014 Mastering the Time Value of Money

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This means a dollar received today has more value to us than a dollar received far in the future. Other than a desire for instant gratification, there is a very rational reason for this phenomenon. If we have a dollar today, we can put it to work by making an investment and have more than a dollar at some future date. This concept of putting the money to work has important implications.

Contents

I. 1 Concept of equivalence

* 1.1 Future worth of a lump sum

* 1.1.1 Example 1: Future value

* 1.2 Present worth of lump sum

* 1.2.1 Example 2: Present value

* 1.3 Annuities and loans

* 1.3.1 Example 3: Loan

* 1.4 Annual vs. monthly interest rates

* 1.4.1 Example 4: Monthly payment calculation

* 1.4.2 Example 5: Monthly payments with effective monthly interest rates

II. Notes

III. References

Concept of equivalence

Another important concept is the concept of equivalence between a current lump sum of money and a lump sum to be received in the future. Offering someone a choice between receiving $100 today and receiving $101 one year from today can demonstrate this. Most people will opt for the $100 today. If we increase the amount of future money to $115 or $125 or perhaps $200 and guarantee payment, there will be a point at which the future sum of money will become more attractive than the current $100. The amount of future money necessary to sway the person to choose the future sum is dependent upon many things, which include, among others:

* The inflation rate

* Current opportunities to invest the $100

* Perceived risk

No matter what the amount of money necessary to tip the scales, the concept that money has a time value is established.

In the case just discussed, if the person is indifferent to receiving $125 one year from now or $100 now, we say that the two sums are "equivalent." This concept of equivalence is fundamental to the evaluation of all engineering projects. We are often faced with the choice of having a certain sum of money now or receiving various sums of money in the future. By determining the equivalence between money received today and money received in the future, we can make an informed decision.

In the previous example, making the choice is relatively simple. There are only two sums to compare, and the time period is one year. This is usually not the case in oil/gas property evaluations, so we need a mechanism to handle complex choices. The mechanism that works best is interest.

We can define interest as the amount of money that must be added to our current sum to make an equivalent future sum. The amount of interest necessary to create equivalence is dependent upon the period under consideration. We may be indifferent to receiving:

* $100 now

* $112.50 six months from now

* $125 one year from now

In that case, the $12.50 or $25.00 is the amount of interest. To easily compare all three...

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