Appendix 4A
Net Present Value: First Principles of Finance
SLIDES
APPENDIX ORGANIZATION
4A.1 Making Consumption Choices over Time
4A.2 Making Investment Choices
4A.3 Illustrating the Investment Decision
ANNOTATED APPENDIX OUTLINE
Slide 4A.0 Appendix 4 Title Slide
Slide 4A.1 Key Concepts and Skills
Slide 4A.2 Appendix Outline
4A.1. Making Consumption Choices over Time
Slide 4A.3 Making Consumption Choices over Time
An individual is assumed to be endowed with a set level of income in two
periods: Time 0 and Time 1. In addition, the individual can use the
financial markets to borrow or lend at the stated interest rate, which allows
consumption to be switched between periods.
Slide 4A.4 –
Slide 4A.5 Intertemporal Consumption Opportunity Set
For example, income from Time 0 can be invested for future use in Time
1, or, alternatively, income from Time 1 can be used today by borrowing
the present value.
4A.1 Key Concepts and Skills
4A.2 Appendix Outline
4A.3 Making Consumption Choices over Time
4A.4 Intertemporal Consumption Opportunity Set
4A.5 Intertemporal Consumption Opportunity Set
4A.6 Taking Advantage of Our Opportunities
4A.7 Changing Our Opportunities
4A.8 Illustrating the Investment Decision
4A.9 Illustrating the Investment Decision
4A.10 Illustrating the Investment Decision
4A.11 Illustrating the Investment Decision
4A.12 Net Present Value
4A.13 Quick Quiz
Slide 4A.6 Taking Advantage of Our Opportunities
Slide 4A.7 Changing Our Opportunities
A person’s preferences determine which point they select—
consumption today or consumption tomorrow.
A change in interest rates rotates the consumption line:
An increase in rates makes future consumption (i.e., saving) more
attractive and current consumption (i.e., borrowing) less attractive.
A decrease in rates has the opposite effect.
4A.2. Making Investment Choices
4A.3. Illustrating the Investment Decision
Slide 4A.8 –
Slide 4A.11 Illustrating the Investment Decision
Suppose an investor is faced with an investment opportunity outside of the
capital markets. If the opportunity presents a return higher than the capital
market, then the opportunity shifts the consumption line outward, which
increases potential consumption in both current and subsequent periods.
Example: Can you have your cake and eat it too?
Upon graduation you are offered a 2-year contract at $50,000 per year
with an investment firm. As a gift to yourself, you want to purchase a
Porsche for $75,000. Your college roommate offers you an opportunity to
invest $25,000 in her Internet start-up business that will produce a 20%
return. The equilibrium (market) interest rate is 5%. Can you satisfy both
your consumption and investment desires? (We will ignore risk in this
example.)
In a world with a well-functioning financial market, you CAN
have your Porsche and invest in your friend’s company.
What will your intertemporal consumption opportunity set be if
you cannot invest in your roommate’s business?
Would you invest in a business that returns only 2%?
In the above example, your investment in the Internet business that returns
20% increases your intertemporal investment opportunities. However,
Slide 4A.12 Net Present Value
We can quantify, in dollars, the benefits of an investment. Since an
individual can always use the financial markets to choose his
intertemporal consumption, financial assets represent an alternative to
investing in real assets. The opportunity cost of investing in real assets is
the equilibrium interest rate that an individual could earn from financial
assets. We can analyze an investment from a “cost-benefit” perspective:
What is the NPV of the business that returns only 2%?
Cost of the investment = $25,000
In other words, investing in this business actually reduces your
consumption opportunity by $714 today or $750 next period.
Rules for the Corporate Manager
The above analysis for individuals is relevant for the corporation
even when:
1. Management and ownership are separate
2. There are many shareholders with different preferences
The separation theorem in financial markets says that all investors
will accept or reject investment projects by using the NPV rule
Slide 4A.13 Quick Quiz