Electric Submersible Pumps Mohamed Dewidar 2013

Chapter 11

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Economics
Table of Content
Section Content Page
1 Simple and compound interest 2
2 Present Value (PV) of Future Value (FV) 3
3 New income project 4
4 Rate Of Return (ROR) 4
Examples 5


























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Economics
9.1. Simple and Compound Interest
Simple interest is the interest paid or received on the
original principal regardless the number of time period that
have passed. Interest rates are reported as annual percentage.
Interest = Principal x Rate x Time
Compound interest is applied to the principal at the end of
one period and added to the existing principal. The total is
then treated as principal again for the second interest period
and so on.
P = Principal : i = interest rate
P
1
= Principal at end of 1
st
year = P[i+1]
P
2
= Principal at end of 2
nd
year = p[i+1]+ p[i+1]*i= p[i+1]
2

P
3
= Principal at end of 3
rd
year = p[i+1]
2
+ p[i+1]
2
* i =
p[i+1]
2
(i+1)=P[i+1]
3

Interest = P[i+1]
3
-P = P([i+1]
3
-1)
Interest = P([i+1]
n
- 1)
Example
A sum of $2000 is invested in a saving account yielding an
annual interest rate of 12%. Compute the interest amount for
one year if:
a. The interest is compounded monthly
b. The interest is compounded quarterly
c. The interest is compounded annually
d. The interest is compounded semiannually
Solution
a. i = 0.12 12 = 0.01 monthly compounding
Interest = 2000*([0.01+1]
12
-1) = $253.65
b. i = 0.12 4 = 0.03 quarterly compounding
Interest = 2000*([0.03+1]
4
-1) = $251.02
c. I = 0.12
Interest = 2000*([0.12+1]
1
-1) = $240.00
d. I = 0.12 2 = 0.06
Interest = 2000*([0.06+1]
2
-1) = $247.20

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9.2. Present Value (PV) of Future Sum (FV)
FV of Principal P (PV) of
1
st
year = P + Pi = P(i+1)
2
nd
year = P(i+1)+P(i+1)i=P(i+1)(i+1)=P(i+1)
2

3
rd
year = P(i+1)
2
+ P(i+1)
2
i = P(i+1)
3

and so on
FV = PV (i+1)
n

PV = FV (i+1)
n
= FV * [1 (i+1)
n
]
The quantity of [1 (i+1)
n
] (is called discount factor
PV = FV * discount factor

Example
Compute PV for next 5 years of FV of $5,000 assuming interest
rate of 12% compounded. (a) Annually, (b) Semiannually
(a) PV = $5,000 (0.12+1)
5
= $2,837.13
(b) i = 0.12/2 = 0.06 : n = 5 years x 2 period per year = 10
PV = $5,000 (0.06+1)
10
= $2,791.97

FV = $2,837.13 x (0.12+1)
5
= $5,000
PV = $2,791.97 x (0.06+1)
10
= $5,000
9.3. New Income Project
Consider a typical new project in which an initial capital
outlay is required for plant. The financial history of such
project may be illustrated by the following graph where
cumulative profit, or loss is plotted vs time.
AB = investment time
BB = Total capital investment
DD = Final profit
BC = Payout time
BD= Earning life of the project
AD = Life of the project
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9.4. Rate of Return (ROR)
To see how rate of return is defined, consider this graph.
As discount rate i increases the point D will approach D and
for some value R of the discount rate point D will coincide
with D. This value R is defined as rate of return of the
project.

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To put another way, if the capital for a certain project is
borrowed from a bank and if profits from the venture are used
to reduce the outstanding debit, then the rate of return of
the project will equal the rate of interest the bank charges
on the outstanding loan if the final profit made at the end of
earning life is just sufficient to cover the final payment to
the bank.
Example 1
The capital cost of a certain project is $31,000, the earning
life of the project is 6 years, the income in these six years
are $5,000, $12,000, $13,000, $12,000, $12,000, and $8,000
respectively. calculate:
a. The undiscounted % profit
b. Discounted value based on discount rate of 10%/year
c. Payout time
d. Rate of return
Solution
a. Undiscounted % profit
Total income = $5,000+$12,000+$13,000+$12,000+$12,000+$8,000 =
$62,000
Undiscounted profit = $62,000-$31,000 = $31,000
Undiscounted % profit = $31,000 $31,000 = 100%
b. The discounted profit
PV = FV x discount factor (1 [i + 1]
n
)

i = discount rate per year



Discounted profit = $46,560 - $31,000 = $15,560
Discounted % profit = $15,554 $31,000 = 50.2%
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What does ROR = 23% mean?
It means that the, if the interest of the bank on the borrowed
money is equal 27.6%, the net profit of the project will be
0%. So, the interest of the bank must be much less than this
ROR.
Example 2
An oil well has reserve of 346,750 STB the life of the well is
5 years. The reserve is distributed among the five years as
following (i.e, cumulative production per year):
The 1
st
year will produce 109,500 STB
The 2
nd
year will produce 73,000 STB
The 3
rd
year will produce 54,750 STB
The 4
th
year will produce 54,750 STB
The 5
th
year will produce 54,750 STB
The expected average oil price is $80/bbl
The capital & operating cost during these 5 years are
$7,000,000 calculate Rate of return.

Capital & Operating cost = $7,000,000 DISCOUNT RATE
Reserve
STB
Month
Undiscounted 20%
Undiscounted
net income
Cumulative
U.D.N.I.

Undiscounted
profit
Discounted
factor
Discounted
net income
Cumulative
D.N.I.
Discounted
profit
0 ($7,000,000) =1 (i+1)
n

109,500 1 8,760,000 8,760,000 1,760,000 0.8333333 7,300,000 7,300,000 300,000
73,000 2 5,840,000 14,600,000 7,600,000 0.6944444 4,055,556 11,355,556 4,355,556
54,750 3 4,380,000 18,980,000 11,980,000 0.5787037 2,534,722 13,890,278 6,890,278
54,750 4 4,380,000 23,360,000 16,360,000 0.4822531 2,112,269 16,002,546 9,002,546
54,750 5 4,380,000 27,740,000 20,740,000 0.4018776 1,760,224 17,762,770 10,762,770
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Capital & Operating cost = $7,000,000 DISCOUNT RATE
Reserve
STB
Month
Undiscounted 40%
Undiscounted
net income
Cumulative
U.D.N.I.

Undiscounted
profit
Discounted
factor
Discounted
net income
Cumulative
D.N.I.
Discounted
profit
0 ($7,000,000) =1 (i+1)
109,500 1 8,760,000 8,760,000 1,760,000 0.71428571 6,257,143 6,257,143 -742,857
73,000 2 5,840,000 14,600,000 7,600,000 0.5102041 2,979,592 9,236,735 2,236,735
54,750 3 4,380,000 18,980,000 11,980,000 0.3644315 1,596,210 10,832,945 3,832,945
54,750 4 4,380,000 23,360,000 16,360,000 0.2603082 1,140,150 11,973,095 4,973,095
54,750 5 4,380,000 27,740,000 20,740,000 0.1859344 814,393 12,787,487 5,787,487

Capital & Operating cost = $7,000,000 DISCOUNT RATE
Reserve
STB
Month
Undiscounted 60%
Undiscounted
net income
Cumulative
U.D.N.I.

Undiscounted
profit
Discounted
factor
Discounted
net income
Cumulative
D.N.I.
Discounted
profit
0 ($7,000,000) =1 (i+1)
109,500 1 8,760,000 8,760,000 1,760,000 0.62500000 5,475,000 5,475,000 -1,525,000
73,000 2 5,840,000 14,600,000 7,600,000 0.390625 2,281,250 7,756,250 756,250
54,750 3 4,380,000 18,980,000 11,980,000 0.2441406 1,069,336 8,825,586 1,825,586
54,750 4 4,380,000 23,360,000 16,360,000 0.1525879 668,335 9,493,921 2,493,921
54,750 5 4,380,000 27,740,000 20,740,000 0.0953674 417,709 9,911,630 2,911,630

Capital & Operating cost = $7,000,000 DISCOUNT RATE
Reserve
STB
Month
Undiscounted 80%
Undiscounted
net income
Cumulative
U.D.N.I.

Undiscounted
profit
Discounted
factor
Discounted
net income
Cumulative
D.N.I.
Discounted
profit
0 ($7,000,000)
109,500 1 8,760,000 8,760,000 1,760,000 0.5555556 4,866,667 4,866,667 -2,133,333
73,000 2 5,840,000 14,600,000 7,600,000 0.308642 1,802,469 6,669,136 -330,864
54,750 3 4,380,000 18,980,000 11,980,000 0.1714678 751,029 7,420,165 420,165
54,750 4 4,380,000 23,360,000 16,360,000 0.0952599 417,238 7,837,403 837,403
54,750 5 4,380,000 27,740,000 20,740,000 0.0529222 231,799 8,069,202 1,069,202

Capital & Operating cost = $7,000,000 DISCOUNT RATE
Reserve
STB
Month
Undiscounted 100%
Undiscounted
net income
Cumulative
U.D.N.I.

Undiscounted
profit
Discounted
factor
Discounted
net income
Cumulative
D.N.I.
Discounted
profit
0 ($7,000,000)
109,500 1 8,760,000 8,760,000 1,760,000 0.5 4,380,000 4,380,000 -2,620,000
73,000 2 5,840,000 14,600,000 7,600,000 0.25 1,460,000 5,840,000 -1,160,000
54,750 3 4,380,000 18,980,000 11,980,000 0.125 547,500 6,387,500 -612,500
54,750 4 4,380,000 23,360,000 16,360,000 0.0625 273,750 6,661,250 -338,750
54,750 5 4,380,000 27,740,000 20,740,000 0.03125 136,875 6,798,125 -201,875
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