Suppose Clifford recently discovers oil in his fields, which greatly excites him

Question

Suppose Clifford recently discovers oil in his fields, which greatly excites him because he can earn a profit of $45.00 per barrel based on present market conditions. Because production costs will be lower in five years, Clifford deduces he can pump the oil out at a profit of $63.00 per barrel if he chooses to wait. If the interest rate currently is 4.00%, what is the present value of the future sum of money? Number $44.53 Based on this calculation, should Clifford pump the oil now or wait? Previous Give Up & View Solution Check Answer NexEx Hint What needs to be considered to make an appropriate evaluation? How does present value fit in?

Explanation / Answer

It has been said in future, the revenue per barrel of oil is $63. The interest rate is 4% or 4/100 = 0.04. The time is 5 years.

Formula for Present Value (PV) = Future Value (FV to be received in future)/(1+i)^n where i= interest rate and n = time in years.

Here, FV = $63. Therefore, PV = 63/(1+0.04)^5

Or PV = $51.78

In this case, $51.78 earned today is equal to earning $63 after 5 years. Therefore is Clifford extracts oil in the present, he will be earning less even after considering interest rates, than he would be earning if he waits for 5 years.

This PV of waiting is greater than the PV according to current market conditions such that $51.78>$45.

Therefore it is better for Clifford to wait and extract oil after 5 years.

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