PET 412E

Petroleum and Natural Gas

Economics

Time value of money

Handout # 3
1

Content

• Introduction
• Compound interest formulas (bileşik faiz formülleri)
• Equations for compound interest factor (bileşik faiz faktörü
formülleri)
• Effective and continues interest rates (efektif ve sürekli faiz
oranları)

Introduction

• The value of money lies in its purchasing power, i.e., the

goods and services which can be acquired through an
exchange of money.
• The value of money is also a function of when it is
received and the length of time over which it is held.
• A basic concept in economic analysis is that the money
has a time value.
• Most people intuitively (içgüdüsel) recognize that money
has time value.
• Example 1) would you rather have $100 now or $105 one
year from now? 2) would you rather have $100 now or
$150 one year from now? 3) would you rather have $100
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now or $200 ten years from now?

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 Introduction

• The answers to the first two questions are obvious. Most

people would accept the $100 in Case 1, but wait for the
$150 in Case 2.
• It is difficult to evaluate Case 3 intuitively. To do this, we
must have rational approach to compare the relative
merits of $100 today with $200 ten years from today.
• Answering the above questions, you implicitly recognized
that money has time value, i.e., dollars in hand can be
invested at some interest rate «i» and as a result, will
increase over time.
• Also, you implicitly recognized that you have a minimum rate of return.

Introduction

• There is some future value for which you will defer

accepting the $100 now.
• A rational approach for comparing options can be
developed using compound interest formulas that provide
the basis for equivalence calculations.

Interest rates serve several functions in the economy.

1) The time value of money is quantified.
2) The expected return on invested capital is quantified.
3) Risk premium paid to investors for not hoarding dollars
but instead making them available to others is quantified.
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Introductions

• Interest rates are normally specified by financial agencies

on a nominal annual basis (often called the Annual
Percentage Rate or APR) with interest compound (earned
interest added to principal) a specific number of times per
year.

Example: If a bank pays 8% interest compounded quarterly, this means

that the nominal annual interest rate (r) is equal to 8% and the number
of annual compounding periods (m) is 4. The period interest rate (i) is
equal to r/m. For this example (i=8/4=2%). Thus, the depositor (mudi)
would receive 2% interest on the principle of his/her account at the
end of each quarterly period. If the total time involved is longer than
one year, the total number of compounding periods (n) is equal to the
number of years involved multiplied by (m). 6

2
 Introduction

Summary:

r – nominal annual interest rate, APR.

m – number of compounding periods per year.
i – period interest rate (i=r/m).
t – number of years being considered.
n – total number of compounding periods (n=m*t).

Compound interest formulas

There are six basic compound interest formulas needed to

apply engineering economy decision methods to compare
investment alternatives.
The following letter symbols will be used in the derivation of
these formulas:
P – present single sum of money. Normally refers to a sum of
money at time zero, but may represent a sum of money at
any point from which we choose to measure time.
F – a future single sum of money at some designated future
time.

Compound interest formulas

A – the amount of each payment in a uniform series of equal

payments made at the end of each period. When the
periods are years, «A» refers to annual payments
n – the number of interest compounding periods in the
project evaluation life.
i – the period compound interest rate (may refer to either the
cost of borrowed money, the rate of return on invested
capital, or the minimum rate of return, depending on the
situation)
A A A A ............................... A A

P F
0 1 2 3 4 ............................... n-1 n
9
Interest periods

3
 Compound interest formulas

There are six different two variable relationships that can be

developed between P, A and F.
Calcalated quantity Given quantity Appropriate factor
F P F/Pi,n
F A F/Ai,n
P F P/Fi,n
P A P/Ai,n
A F A/Fi,n
A P A/Pi,n

Calculated quantity = Given quantity * Appropriate factor

10

Compound interest formulas

In the table above, the first latter in the factor designates

the quantity that the factor calculates while the second letter
designates the quantity given. The first subscript on the
factor is the period of interest rate (i) and the second is the
number of interest compounding periods (n).

There are only three basic types of time value of money

calculations:
1) Calculation of future value (F) from either P or A
2) Calculation of uniform and equal annual value (A) from
either F or P
3) Calculation of present values (P) from either F or A. 11

Compound interest formulas

Single payment compound amount factor, (F/Pi,n) “tek

ödeme bileşik değer çarpanı”
The factor F will be computed using given P.
1st period: F1=P+iP=P(1+i)
2nd period: F2=P(1+i) + iP(1+i)= P(1+i)2
3rd period: F3=P(1+i)2 + iP(1+i)2=P(1+i)3
..
nth period: Fn=P(1+i)n-1 + iP(1+i)n-1=P(1+i)n

F=P(1+i)n or F/Pi,n=(1+i)n
12

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 Compound interest formulas

Example 1: Tek ödeme bileşik değer çarpanı, (F/Pi,n)

“single payment compound amount factor”

Compute the amount of money you will have in 10 years if

you invest $2000 today and $1500 six years from today.
The interest rate is 8% compounded annually

1500

2000 F
0 1 2 3 4 5 6 7 8 9 10
Interest periods
13

Compound interest formulas

Solution 1: Tek ödeme bileşik değer çarpanı, (F/Pi,n)

“single payment compound amount factor”

r=8% m=1 i=r/m=8/1=8%

t=10 years n=m*t=1*10=10 periods

F=2000 (F/P8%,10) + 1500 (F/P8%,4)

F=2000 (1+0.08)10+1500 (1+0.08)4
F=2000 (2.1589) + 1500 (1.3605)
F = $6359
14

Compound interest formulas

Example 2: Tek ödeme bileşik değer çarpanı, (F/Pi,n)

“single payment compound amount factor”

How long it takes to double your money if you can invest at

an APR of 12% compounded annually?

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5
 Compound interest formulas

Solution 2: Tek ödeme bileşik değer miktarı, (F/Pi,n) “single

payment compound amount factor”

r=12% m=1 i=r/m=12/1=12%

t=? Years n=m*t=1*?=? period F=2P

F=P (F/P12%,n) = 2P
(F/P12%,n) = (1+0.12)n=2
n= 6.12 periods

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Compound interest formulas

Classroom application: Tek ödeme bileşik değer çarpanı,

(F/Pi,n) “single payment compound amount factor”

How long does it take to double your money if you invest at

an APR of (1) 3%, (2) 30% and, (3) 60% compounded
annually?

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Compound interest formulas

Alternate solution 2: Tek ödeme bileşik değer çarpanı,

(F/Pi,n) “single payment compound amount factor”

Rule of 72: If you divide the period interest rate (expressed

as percentage) into 72 the result is the approximate number
of interest periods required to double your money.

n=72/12=6 periods

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 Compound interest formulas

Tek ödeme şimdiki değer çarpanı, (P/Fi,n) “single payment

present worth factor”

F  P (1  i) n is solved for P;

1 1 1
PF or P / Fi ,n  
(1  i) n (1  i) n F / Pi ,n

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Compound interest formulas

Example 3: Tek ödeme şimdiki değer çarpanı, (P/Fi,n)

“single payment present worth factor”

You have the options of receiving $1000 now or $2000

eight years from now. If you can invest money at an annual
interest rate of 12% compound quarterly, what should you
do?

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Compound interest formulas

Solution 3: Tek ödeme şimdiki değer çarpanı, (P/Fi,n)

“single payment present worth factor”

r=12% m=4 i=r/m=12/4=3%

t=8 years n=m*t=4*8=32 period
Computing the present value of $2000 yields:

1
P  2000P / F%3,32   2000  2000 * 0.3883  $777
(1  0.03) 32
Decision option: take the $1000 payment now.
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 Compound interest formulas

Düzgün seriler bileşik miktar çarpanı, (F/Ai,n) “uniform

series compound amount factor”

F will be computed using given A.

A A A A ............................... A A

P F
0 1 2 3 4 ............................... n-1 n
Interest period

FA
1  i n  1 or F / Ai , n 
1  i n  1
i i 22

Compound interest formulas

Example 4: Düzgün seriler bileşik miktar çarpanı, (F/Ai,n)

“uniform series compound amount factor”

You are paying $2000 per year into an individual retirement

account «IRA». If you are earning 10% interest,
compounded annually, what will be the value of the account
at the end of 30 years.

2000 2000 2000 ............................... 2000 2000

F
0 1 2 3 ............................... 29 30
Interest periods 23

Compound interest formulas

Solution 4: Düzgün seriler bileşik miktar çarpanı, (F/Ai,n)

“uniform series compound amount factor”

r=10% m=1 i=r/m=10/1=10%

t=30 years n=m*t=1*30=30 periods

F / A%10,30  2000
1  0.130  1  2000 *164.4940  $328,988
0.1

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 Compound interest formulas

Düzgün seriler azalan fon çarpanı, (A/Fi,n) “uniform series

sinking fund factor”

A will be computed for given F.

FA
1  i n  1
will be used. Solving for A;
i

i i 1
AF or A / Fi , n  
1  i n  1 1  i n  1 F / Ai ,n
25

Compound interest formulas

Example 5: Düzgün seriler azalan fon çarpanı, (A/Fi,n)

“uniform series sinking fund factor”

A recent petroleum engineering graduate is 20 years old.

He would like to retire at age sixty with $1,000,000 in
his/her investment account. He/she believes that he/she will
be able to invest money at an average annual interest rate
of 12% compounded monthly. What monthly amount must
be invested? Assume end of month deposits.

26

Compound interest formulas

ÇÖZÜM 5: Düzgün seriler azalan fon çarpanı, (A/Fi,n)

“uniform series sinking fund factor”

r=12% m=12 i=r/m=12/12=1%

t=(60-20)=40 years n=m*t=12*40=480 periods
A A A ............................... A A
F=1000000
0 1 2 3 ............................... 479 480
Interest periods

A  1000000 A / F%1, 480   1000000

0.01
 $85
1  0.01480  1
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NOTE: Amount invested =480*85 = $40,800

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 Compound interest formulas

Düzgün seriler şimdiki değer çarpanı, (P/Ai,n) “uniform

series present worth factor”

P will be calculated for given A.

F  P1  i 
n
FA
1  i n  1
i
Equating above equations and solving for P;

PA
1  i n  1 or P / Ai ,n 
1  i n  1
i 1  i  i1  i 
n n

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Compound interest formulas

Example 6: Düzgün seriler şimdiki değer çarpanı, (P/Ai,n)

“uniform series present worth factor”

A friend has approached you and offered to sell a producing

property for $800,000. You investigate and determine that you
can produce 6000 stb of oil per year (your share) from the
property for 10 years. If you can make a net profit of $20 per
stb over the next ten years and your opportunity rate for other
investments is 10% per annum compounded annually, would
you buy the property?

29

Compound interest formulas

Solution 6: Düzgün seriler şimdiki değer çarpanı, (P/Ai,n)

“uniform series present worth factor”

If the future revenues have present value greater than

$800,000 you will accept the offer, if equal to $800,000 you
will be indifferent to the offer, if less than $800,000 you will
reject the offer, you can earn more by investing your money at
10% per annum
Since your time value of money is 10% per annum, the future
sums of money will be discounted (iskonto) to the present at
that rate.
30

10
 Compound interest formulas

Solution 6: Düzgün seriler şimdiki değer çarpanı, (P/Ai,n)

“uniform series present worth factor”

r=10% m=1 i=r/m=10/1=10%

t=10 years n=m*t=1*10=10 periods
A=6000*20=120,000=120M

120M 120M 120M ............................... 120M 120M

P F
0 1 2 3 ............................... 9 10
Interest periods 31

Compound interest formulas

ÇÖZÜM 6: Düzgün seriler şimdiki değer çarpanı, (P/Ai,n)

“uniform series present worth factor”

P  120M P / A%10,10  
1  0.110  1  $737352  $800,000
0.11  0.1
10

Reject the offer.

32

Compound interest formulas

Düzgün seriler sermaye geri kazanım çarpanı, (A/Pi,n)

“uniform series capital recovery factor”

A will be computed for given P.

i 1  i  i 1  i 
n n
1
AP or A / Pi ,n  
1  i n  1 1  i   1
n
P / Ai ,n

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 Compound interest formulas

Example 7: Düzgün seriler sermaye geri kazanım çarpanı,

(A/Pi,n) “uniform series capital recovery factor”

You find a sleek red sports car that you must have. The
friendly car salesman tells you the price is $40,000 but he
can «let you have it» for $2169 down and a low monthly
note of $900 for five years. What interest rate is he
charging you?

34

Compound interest formulas

ÇÖZÜM 7: Düzgün seriler sermaye geri kazanım çarpanı,

(A/Pi,n) “uniform series capital recovery factor”

r=%? m=12 i=r/m=r/12=?%

t=5 years n=m*t=12*5=60 periods
Balance to be financed: 40000-2169 = $37831

900 900 900 ............................... 900 900

0 1 2 3 ............................... 59 60
P=$37831 Interest periods 35

Compound interest formulas

Solution 7: Düzgün seriler sermaye geri kazanım çarpanı,

(A/Pi,n) “uniform series capital recovery factor”

A  P A / Pi , 60   900  37831A / Pi ,60 

A / P  
i , 60
900
 0.02379
37831
𝑖 1+𝑖
= 0.02379 ⇒ 𝑖 = 1.25%
1+𝑖 −1
r=(i*m)=1.25*12=15% (he truly «let you have it» didn’t he?)
36

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 Compound interest formulas

Mid-period factor, “Orta-dönem çarpanı”

• An assumption in handling the time value of money that finds
considerable use in the oil and gas industry is that all values
of cost and income after time zero occur at the middle of
interest periods rather than the end of periods.
• This does not present a problem for the single sum factors
(F/P and P/F), but the uniform series factors (F/A, A/F, P/A
and A/P) must be modified.
A A A A A
...........................
P F
0 1 2 3 ........................... n-2 n-1 n
Interest periods 37

Compound interest formulas

Orta-dönem çarpanı, “mid-period factor”

1+𝑖 −1 / /
𝐹/𝐴 , = 1+𝑖 = 𝐹/𝐴 , 1+𝑖
𝑖

1 /
𝐴/𝐹 , = = 𝐴/𝐹 , 1+𝑖
𝐹/𝐴 ,

NOTE: MP=mid-period EP=end-period

38

Compound interest formulas

Orta-dönem çarpanı, “mid-period factor”

P / A  i , n MP  P / Ai ,n EP 1  i 
1 / 2

A / P  i , n MP   A / Pi ,n EP 1  i 
1/ 2

NOTE: MP=mid-period EP=end-period

39

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 Compound interest formulas

Orta-dönem çarpanı, “mid-period factor”

The present and future values assuming mid-period cash

flows versus end-of-period cash flows will be different.
However, these differences will be small and should not
affect the economic decision reached when comparing
project A with project B.

In this course, end-of-period (EP) cash flow will be

assumed.

40

Effective and continuous interest rates

An effective annual interest rate (E) is the interest rate

that, when applied once per year to a principle sum, yields
an interest amount equal to that obtained when a nominal
annual interest rate of “r” compounded “m” times per year
applied.
Suppose we have a present value, P. Compute the future
value at the end of one year using nominal annual interest
rate r compounded m times per year:
i=r/m
F1=P(F/Pi,m )=P(1+i)m

41

Effective and continuous interest rates

Compute the future value at the end of one year using

interest rate E compounded (applied) once for the year:

F2=P(1+E)1

For E to be effective interest rate, F1 must equal F2 ;

hence:

E  (1  i ) m  1 (note : E  F / Pi , m  1)

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 Effective and continuous interest rates

Since, i=r/m

r m
E  (1  ) 1
m
If we let the number of compounding periods per year
become very large, the period interest rate becomes very
small. In the limit as m approaches infinity, the period
interest rate approaches zero and we have the
continuous interest situation. Therefore,

43

Effective and continuous interest rates

Effective and continuous interest rate

𝑟
𝐸 = lim → (1 + ) −1 = 𝑒 −1
𝑚

44

Effective and continuous interest rates

Example 8:

Most credit card companies (banks) charge an APR of

18% compounded monthly on the unpaid balance of your
account.

Compute the effective annual interest rate.

Also, compute the effective annual interest rate assuming

continuous compounding and daily compounding.
45

15
 Effective and continuous interest rates

Solution 8:

Monthly compounding:
r=18% m=12
E=(1+0.18/12)12 - 1=0.1956 or 19.56%

Continuous compounding:
Econtinuous=e0.18 - 1=0.1972 or 19.72%

Daily compounding:
E=(1+0.18/365)365 - 1=0.1972 or 19.72% 46

Preparing interest rates tables_2023-24

Prepare tables similar to shown below. You will use this tables in the
exams. Tables should be prepared for different interest rates (i) and
periods (n). Keep 4 digits for the factors.
(for example, i=1, 2, 3, 4, 5, 6, 8, 9, 10, 12, 15, 18, 20, 25, 30, 40, and 50
and n=1,….,50).

n P/F P/A F/P F/A A/P A/F

1 0,9901 1,0100

2 0,9803 1,0201

i=1 3 0,9706 1,0303

…. … …

49 0,6141 1,6283

50 0,6080 1,6446
47

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