Discussion Topic #1
jandreg
chap004a1.pptNet Present Value: First Principles of Finance
Appendix 4A
Copyright © 2013 by the McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
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Key Concepts and Skills
- Understand the theoretical foundations of the Net Present Value (NPV) rule
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Appendix Outline
4A.1 Making Consumption Choices over Time
4A.2 Making Investment Choices
4A.3 Illustrating the Investment Decision
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Making Consumption Choices over Time
- An individual can alter his consumption across time periods through borrowing and lending.
- We can illustrate this by graphing consumption today versus consumption in the future.
- This graph will show intertemporal consumption opportunities.
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Intertemporal Consumption Opportunity Set
A person with $95,000 who faces a 10% interest rate has the following opportunity set.
One choice available is to consume $40,000 now; invest the remaining $55,000; consume $60,500 next year.
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
Consumption today
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
Consumption at t+1
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Intertemporal Consumption Opportunity Set
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
Consumption today
Consumption at t+1
Another choice available is to consume $60,000 now; invest the remaining $35,000; consume $38,500 next year.
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Taking Advantage of Our Opportunities
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
Consumption today
Consumption at t+1
A person’s preferences will determine what point on the opportunity set she will choose.
Ms. Patience
Ms. Impatience
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Changing Our Opportunities
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
Consumption today
Consumption at t+1
A rise in interest rates will make saving more attractive …
…and borrowing less attractive.
Consider an investor who has chosen to consume $40,000 now and to consume $60,000 next year.
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The point at which the intertemporal opportunity set pivots depends upon where your endowment is when interest rates change. If the person had $95,000 in current consumption and no future consumption, the pivot would have been at the x-axis intercept.
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Illustrating the Investment Decision
- Consider an investor who has an initial endowment of income of $40,000 this year and $55,000 next year.
- Suppose that she faces a 10-percent interest rate and is offered the following investment.
Cash inflows
Time
Cash outflows
0
1
-$25,000
$30,000
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Illustrating the Investment Decision
$0
Consumption today
Our investor begins with the following opportunity set: endowment of $40,000 today, $55,000 next year and a 10% interest rate.
One choice available is to consume $15,000 now; invest the remaining $25,000 in the financial markets at 10%; consume $82,500 next year.
$0
$99,000
Consumption at t+1
$90,000
$55,000
$82,500
$40,000
$15,000
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Illustrating the Investment Decision
$0
Consumption today
A better alternative would be to invest in the project instead of the financial markets.
She could consume $15,000 now; invest the remaining $25,000 in the project at 20%; consume $85,000 next year.
$0
$99,000
Consumption at t+1
$90,000
$55,000
$82,500
$40,000
$85,000
$15,000
With borrowing or lending in the financial markets, she can achieve any pattern of cash flows she wants—any of which is better than her original opportunities.
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Illustrating the Investment Decision
$0
Consumption today
Note that we are better off in that we can command more consumption today or next year.
$0
$99,000
Consumption at t+1
$101,500
$101,500 = $15,000×(1.10) + $85,000
$90,000
$92,273
$55,000
$82,500
$40,000
$85,000
$15,000
$92,273 = $15,000 +
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Net Present Value
- The value created by the investment opportunity increased our possible consumption.
- This opportunity, therefore, created value.
- The current value of the opportunity is the investment’s NPV.
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Quick Quiz
- What factors determine our consumption next year?
- How do investment opportunities create value?
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