How PV (present value) works

I've read some articles, still unsure on something. Use an oil deal between two companies as an example. Say you (seller) own leases that buyer and seller agree that for simplicity's sake, over the next 30 years the leases should generate $25,000 a month income. It's really not the way lease income would occur on an oil lease (flat rate same each  month) but it's for illustrative purposes to use something simple. Disregarding taxes for now. Or would buyers calculate atax numbers? (Income tax)

So, say projected income will average $25k/month income and end at zero. If I did my Excel calc correctly, the PV using an interest rate of 10% says PV = $2,872,510. Using 5%, PV = $4,676,445

Not exactly sure what this means, lol. I assume that this interest rate is what is often called the discount rate or do I have that wrong. What IS this interest rate signifying? Is this a rate that we are assuming you could earn with your money? It seems I have often seen 10% used but I wonder if that's realistic. I mean, wouldn't anyone jump for joy if they could earn 10% these days? Should it be less these days?

I guess if the buyer and seller were trying to arrive at a number they both agree on, this interest rate is key! Looking at results above, would not the seller prefer to use 5% and the seller would rather it be 10%? I hope somebody can shed some light on this. Why do you choose a certain interest rate?

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This is a good question and a hard one to answer.  We sold a producing tract three years ago at nearly the peak of the boom in the Permian.  It had two wells on it and was producing for us about $20,000/mo of income which was steadily declining.  The buyer looked at how many new wells could be developed and based their price on that in addition to what the income stream might look like if the operator developed the property to it's potential.  There is no way as only a royalty interest owner you can force an operator to develop unless you have a lease with a good continuous production clause.  In our case the lease was 50 years old and didn't have such a clause so the property was held by stripper wells and the deep rights had been severed but were maintained under the same lease as the strippers which wasn't favorable to the lessor so not a really great property for us.

I decided that the best way to look at selling this property was realizing x number of years of current income now at a known tax rate, i.e. LTCG.  In that case it made sense to me that an offer which provided 15 years current income at LTCG tax rate now would be a fair deal for us irrespective of whatever future development might take place.  That is the speculative part the buyer is engaged in and that we would have been engaged in by holding on.  It's always worthwhile to hedge your holdings and in selling this one at the peak, we were hedging against eventual decline in value for a known value now.  The buyer was looking at how much they could potentially gain in the future and was buying for speculation.  We used entirely different models to arrive at our deal price but we agreed on $3m for our interest in that section which was only 4.15% decimal interest in any oil and gas revenues.  The pricing was based on a royalty acre assuming a 25% decimal interest per acre.  Very complex analysis and calculations on both sides to come up with a deal number. 

Interest rates had nothing to do with our calculations as you can't put your money at interest to gain the kind of return we were getting on the land at the time. I am not sure the buyer cared much about interest rates either because they were a purchaser of royalty interests and had large blocks of investor cash to spend.  To date, no additional wells have been drilled on that tract but we have gotten 8 new ones on our other two that we held on to.

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1 hour ago, BillKidd said:

 

 I assume that this interest rate is what is often called the discount rate or do I have that wrong. What IS this interest rate signifying? Is this a rate that we are assuming you could earn with your money? It seems I have often seen 10% used but I wonder if that's realistic. I mean, wouldn't anyone jump for joy if they could earn 10% these days? Should it be less these days?

I guess if the buyer and seller were trying to arrive at a number they both agree on, this interest rate is key! Looking at results above, would not the seller prefer to use 5% and the seller would rather it be 10%? I hope somebody can shed some light on this. Why do you choose a certain interest rate?

In a discounted net present value analysis, you are attempting to calculate what the value is, today, of an income stream you project into the future.  The "interest rate" is the discount rate.  Typically the interest rate chosen would be the Treasury Bill rate which would be for the same timeline of the projected asset income stream.  I.E. if you have a producing asset with income stream calculated to last ten years, you could use the 10-year T-bill rate, as established at the T-bill auction.  You would NOT use some artificial bank rate such as LIBOR  ("London Inter-bank Offered Rate," which is this artifice created by bankers and designed to screw over the ordinary man who borrows money, on say his home mortgage loan or his credit cards. 

There are some interesting results from using this powerful tool in financial analysis. Paul O'Neill was appointed Secretary of the Treasury by George Bush in 2001.  O'Neill came out of retirement as the Chairman and CEO of Alcoa, in Pittsburgh. At one point he did a net present value analysis on all the future revenue streams coming in to the Administration, taking into account the Bush Tax Cuts.  then he did a NPV analysis on all the government liabilities into the future, including military pensions and social security and medicare.  He discovered that the US Government was totally, hopelessly broke.   

So he took his results to a meeting with George and Dick Cheney, the notorious vice president. The idea was for the Government to come up with an Action Plan that would not hurt the economy or the more vulnerable populations.   At that meting, Cheney growled, "I don't give a damn about some deficit crap."   O'Neill left.  Cheney then sent a message to O'Neill that night saying O'Neill was fired.  Paul went into his office, cleaned it out, and took the night train back to Pittsburgh, not even bothering to write up a Letter of Resignation.  He just walked.  Smart move. 

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