A farmer discovers a natural gas reserve on his property. He can extract the natural gas for a profit of $70 per unit now, $72 per unit in one year, $74 per unit in two years, and $76 in three years. The current market rate of interest is 4 percent. When should the farmer extract the natural gas to obtain the most profit per unit in present value terms?

Question

Quizplus · Accepted Answer

To find the most profit per unit in present value terms, we discount the future profits back to their present value using the formula PV = FV / (1 + r)^n, where PV is the present value, FV is the future value, r is the interest rate, and n is the number of years. Calculating for each option: Today = $70; One year = $72 / (1.04)^1 = $69.23; Two years = $74 / (1.04)^2 = $68.49; Three years = $76 / (1.04)^3 = $67.76. The highest present value is for extracting the gas today at $70.

A Farmer Discovers a Natural Gas Reserve on His Property