Appendix 4A

Net Present Value: First Principles of Finance

Key Concepts and Skills
Understand the theoretical foundations of the Net
Present Value (NPV) rule

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4A-1
Appendix Outline
4A.1 Making Consumption Choices over Time
4A.2 Making Investment Choices
4A.3 Illustrating the Investment Decision

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4A-2
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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4A-3
Intertemporal Consumption Opportunity Set
A person with $95,000 who faces a 10%
Consumption at

$120,00
0 interest rate has the following opportunity set.
$100,00
0
One choice available is to consume
$80,00
$40,000 now; invest the remaining
t+1

$60,00
$55,000; consume $60,500 next year.
0

$40,00
0

$20,00
0

$
0 $0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000

Consumption
today 4A-4
Intertemporal Consumption Opportunity Set

Another choice available

Consumption at

$120,000

is to consume $60,000
$100,000
now; invest the remaining
$80,000
$35,000; consume
t+1

$38,500 next year.

$60,000

$40,000

$20,000

$0
$0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000

Consumption
today
4A-5
Taking Advantage of Our Opportunities
Consumption at

$120,000
A person’s preferences will
$100,000
determine what point on the
Ms.
opportunity set she will choose.
Patience
$80,000
t+1

$60,000

$40,000
Ms.
Impatience
$20,000

$0
$0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000

Consumption
today
4A-6
Changing Our Opportunities
Consider an investor who has chosen
to consume $40,000 now and to
Consumption at

$120,000

consume $60,000 next year.

$100,000

A rise in interest rates will

$80,000
make saving more attractive …
t+1

$60,000

…and borrowing less attractive.

$40,000

$20,000

$0
$0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000

Consumption
today 4A-7
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 $30,000

Time 0

Cash outflows 1
-$25,000

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4A-8
Illustrating the Investment Decision
One choice available is to consume
$15,000 now; invest the remaining
Consumption at

$25,000 in the financial markets at 10%;

$99,000 consume $82,500 next year.
$82,50
0
Our investor begins with the
t+1

following opportunity set:

$55,00 endowment of $40,000
0
today, $55,000 next year and
a 10% interest rate.

$0
$0 $15,000 $40,000 $90,000
Consumption
today
4A-9
Illustrating the Investment Decision
A better alternative would be to invest in the
project instead of the financial markets.
Consumption at

She could consume $15,000 now; invest the remaining

$99,000
$25,000 in the project at 20%; consume $85,000 next year.
$85,00
0$82,50
0 With borrowing or lending in the
t+1

financial markets, she can achieve any

$55,00 pattern of cash flows she wants—any
0
of which is better than her original
opportunities.

$0
$0 $15,000 $40,000 $90,000

Consumption
today 4A-10
Illustrating the Investment Decision
Note that we are better off in that we can
command more consumption today or next year.
Consumption at

$101,500 $101,500 = $15,000×(1.10) + $85,000

$99,000
$85,00
0$82,50
0
t+1

$55,00
0

$92,273 = $15,000 +

$0
$0 $15,000 $40,000 $90,000 $92,273

Consumption
today 4A-11
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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4A-12
Quick Quiz
What factors determine our consumption next year?
How do investment opportunities create value?

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4A-13