Part 1:You are the chief financial officer of a firm. The firm has an expected liability (cash outflow) of $2 million in ten years at a discount rate of 5%.Calculate the amount the firm would need on

48 Alaska Business Monthly | February 2017 www.akbizmag.com

T ime -Value

of Money

A brief lesson in economics

ECONOMY

By Darryl Jordan

“

fear that we must confess to a failure of ice as an element of territorial wealth, as least as far as this immediate region is concerned. I find that the Russian-American Company, whose monopoly was abolished by the treaty of acquisition, depended for ice ex - clusively upon the small lake or natural pond which furnishes power for your saw-mill in this town, and that this dependence has now failed by reason of increasing mildness of winter,” said William Seward, Secretary of State, at Sitka August 12, 1869. For many years, Alaska salmon was packed in ice and sawdust at Sitka for its sale in California.

While some will laugh at “ice” being a ter - ritorial wealth, others will see the irony of “Seward’s Icebox” running out of ice. Yet, others will not believe that global warm - ing had already begun before the industrial age. The real story is that most people will remember Seward for the Alaska purchase price of $7.2 million dollars and forget the real cost was much higher. In 1867, $7.2 mil - lion could buy a lot of goods and services in the “Lower 37 states.” By 1909 the cost to mail a one-ounce letter dropped to two cents,

about the per acre cost of Alaska in 1867. The fact that a first class stamp costs twenty-four times more today is significant to all Alaska businesses—as is the fact that one would be lucky to find land at two cents an acre.

Relative Terms The harsh reality is that the dollar of 2017 cannot buy as many goods and services as it could in 1867. Using historical inflation rates of 3.5 percent per year as the discount factor, Alaska’s cost of $7.2 million in constant dol - lars (1867) becomes more than $1.25 billion in inflated 2017 dollars. Increase the discount rate to 7 percent and it becomes more than $184 billion. Still a great deal, but it is im -

portant to talk about money in relative terms such as time and discount rates. Time erodes the buying power and in Alas - ka, the projects developed here must not forget about the erosion of buying power. On proj - ects where all the materials and services can be bought in a relatively short period of time, prices probably will not change substantially and the reduction in buying power can be safely ignored. What is different about Alaska is that we are collectively at the end of the sup - ply chain, the available labor is in short sup -

ply, and infrastructure is non-existent outside of a very small envelope. The net effect is that Alaska projects are vastly more expensive and take that much more project time to develop. A representative example is the completion time for a North Dakota fractured oil well. Time to drill the well, fracture the formation to produce oil, and complete the well is av - eraging six weeks. In Alaska, three years for planning and permitting and three years to build the infrastructure (such as roads, pads, airstrips, camps, power, water, and waste sys - tems) will finally allow operations to begin. In North Dakota, the erosion of buying power is not a factor; however, Alaska businesses must heavily invest over a number of years before a

return on investment is even possible.

Compounded Impact Two factors evolve as a result. Alaska projects must be huge in order to pay for the more expensive project and more time that will be required. As a result, Alaska businesses must factor in the Time-Value of Money (TVM). The longer an investor has to put money into the project will increase both the risk of re - turn and the value of the money returned from the investment. If an investor wants just

The longer an investor has to put money into the project will increase both the risk of return

and the value of the money returned from the investment.

William H. Seward was commemorated in celebration of the Alaska-Yukon-Pacific Exposition of 1909. There may be some humor in that the value of the stamp is roughly the amount paid per acre for Alaska in 1867.

First Day Issue and Stamp: © Siegel Auction GalleriesUS Treasury Check: ourdocuments.gov www.akbizmag.com February 2017 | Alaska Business Monthly 49

Darryl Jordan is an engineer and writes from Anchorage.

a 10 percent return from their investment and the money doesn’t start coming back for three years, the investor has to count the lack of revenue from the money invested for those three years. At 10 percent compounded annu - ally, the investment is now a third larger (due to the fact that that money could have been returning interest if not invested in this proj - ect). Make it a seven-year project before reve - nue comes back and the expected value of the investor’s investment is an additional 100 per - cent over the original investment cost. If one invests $3 billion in a gold mine expecting a 10 percent return and the project expands from three years to seven years, the expected value of the investment just went from $4 bil - lion to $6 billion. Now add that the revenue returned in the future is worth a lot less in TVM terms and the impact is compounded.To avoid being an Alaska business involved with “Seward’s Folly,” we all need to be con - versant in TVM. When we talk about costs or expenses, we should state the year the costs are expended. Alaska was purchased for $7.2 million in actual 1867 dollars. Today, 2 bil - lion barrels of oil appears recoverable on the North Slope and at $45 a barrel that would be worth $90 billion in nominal dollars. How - ever, that assumes it could be sold instantly, and reality is it may take twenty years, reduc - ing the value to $25 billion in real dollars dis - counted at 10 percent annually.“Time is Money” and in Alaska, the effects are compounded. Pun intended! R

Dollar Terms

e should all be familiar with the nu - merous terms associated with at - tempting to describe the effects of the erosion of time. Some authors use the terms constant dollars, inflated dollars, real dollars, actual dollars, as-spent dollars, and nominal dollars. If this helps, Alaska was bought in ac - tual or nominal dollars for $7.2 million. When using the term constant dollars, one should state the date upon which those dol - lars were “locked” into place. For example, Alaska was bought for $7.2 million constant dollars (1867). If adjusted for inflation, it is possible to state Alaska was purchased for $184 billion constant dollars (2017 assuming a 7 percent discount rate). As-spent dollars look like actual or nominal dollars if spent in the same time frame, but if the project spend - ing spans multiple years, it should represent the total actual dollars spent over time. Real dollars and inflated dollars should take into account that the value of the dol - lar spent or received has changed over time. When using the term real or inflated dollars, the audience needs to know how the author adjusted the dollar to take into account the Time-Value of Money effect. R

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