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→Present value
==Present value==
==Present value==
[[File:Rose_time-value-of-money_1.png|300px|thumb|'''Figure 1.''' Comparison of project cash flows and equivalent present value.]]
This same equation can be rearranged to solve for the equivalence (or present value) of a future sum of money (such as a project net cash flow) received some time in the future. For example, a dollar that we expect to receive one, two, and three years hence is worth today $0.909, $0.826, and $0.751, respectively, if the time value of money is 10% per year compounded annually. This equation expresses this principle of present value:
This same equation can be rearranged to solve for the equivalence (or present value) of a future sum of money (such as a project net cash flow) received some time in the future. For example, a dollar that we expect to receive one, two, and three years hence is worth today $0.909, $0.826, and $0.751, respectively, if the time value of money is 10% per year compounded annually. This equation expresses this principle of present value:
:<math>P = \frac{F}{(1 + i)^t}</math>
:<math>P = \frac{F}{(1 + i)^t}</math>
The present value concept is important in petroleum economics because we need to know how to place a value on cash flows to be received from production in future years. This concept is demonstrated in [[:Image:Rose_time-value-of-money_1.jpg|Figure 1]]. In oil and gas property evaluation, profit is measured in terms of net cash inflows and net cash outflows. In the figure, the horizontal line represents time, the vertical arrows above the horizontal line represent net cash inflows, and the vertical arrows below the horizontal line represent net cash outflows. The profit is usually measured for increments of one year. One exception is the time 0 profit period. Time 0 is the instant in time when the first significant expenditure is made.
The present value concept is important in petroleum economics because we need to know how to place a value on cash flows to be received from production in future years. This concept is demonstrated in [[:Image:Rose_time-value-of-money_1.jpg|the figure]]. In oil and gas property evaluation, profit is measured in terms of net cash inflows and net cash outflows. In the figure, the horizontal line represents time, the vertical arrows above the horizontal line represent net cash inflows, and the vertical arrows below the horizontal line represent net cash outflows. The profit is usually measured for increments of one year. One exception is the time 0 profit period. Time 0 is the instant in time when the first significant expenditure is made.
When each of the future net cash flows are discounted to time 0 using the present value equation, the resulting net cash flow is called the ''net present value'' and is equivalent to the project cash flows at the assumed discount rate. The equivalent time 0 net cash flow is also shown in the figure.
When each of the future net cash flows are discounted to time 0 using the present value equation, the resulting net cash flow is called the ''net present value'' and is equivalent to the project cash flows at the assumed discount rate. The equivalent time 0 net cash flow is also shown in the figure.