Appendix 4A

Net Present Value: First Principles of Finance

Copyright © 2019 McGraw-Hill Education. All rights reserved.

No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Key Concepts and Skills
 Understand the theoretical foundations of the Net
Present Value (NPV) rule

Copyright © 2019 McGraw-Hill Education. All rights reserved.

No reproduction or distribution without the prior written consent of McGraw-Hill Education.
4A-2
Appendix Outline

4A.1 Making Consumption Choices over Time

4A.2 Making Investment Choices
4A.3 Illustrating the Investment Decision

Copyright © 2019 McGraw-Hill Education. All rights reserved.

No reproduction or distribution without the prior written consent of McGraw-Hill Education.
4A-3
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.

Copyright © 2019 McGraw-Hill Education. All rights reserved.

No reproduction or distribution without the prior written consent of McGraw-Hill Education.
4A-4
Intertemporal Consumption Opportunity Set - I
Consumption at t+1

A person with $95,000 who faces a 10%

$120,000
interest rate has the following opportunity set.
$100,000

One choice available is to consume

$80,000
$40,000 now; invest the remaining
$ 60 $55,000;
, 500  $ 55 , 000consume
 (1 . 10 )
1
$60,500 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
Intertemporal Consumption Opportunity Set – II
Consumption at t+1

$120,000
Another choice available
is to consume $60,000
$100,000
now; invest the remaining
$80,000
$35,000; consume
$38,500 next year.
$60,000

$40,000

$ 38 , 500  $ 35 , 000  (1 . 1 0 ) 1
$20,000

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

Consumption today
4A-6
Taking Advantage of Our Opportunities
Consumption at t+1

$120,000
A person’s preferences will
$100,000
determine what point on the
Ms. Patience
opportunity set she will choose.
$80,000

$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-7
Changing Our Opportunities
Consider an investor who has chosen
Consumption at t+1

$120,000
to consume $40,000 now and to
consume $60,000 next year.
$100,000

A rise in interest rates will

$80,000
make saving more attractive …
$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-8
Illustrating the Investment Decision - I
 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

Copyright © 2019 McGraw-Hill Education. All rights reserved.

No reproduction or distribution without the prior written consent of McGraw-Hill Education.
4A-9
Illustrating the Investment Decision – II
One choice available is to consume
Consumption at t+1

$15,000 now; invest the remaining

$25,000 in the financial markets at 10%;
$99,000 consume $82,500 next year.
$82,500
Our investor begins with the
following opportunity set:
$55,000 endowment of $40,000
today, $55,000 next year and
a 10% interest rate.

$0
$0 $15,000 $40,000 $90,000
Consumption today
4A-10
Illustrating the Investment Decision - III
A better alternative would be to invest in the
Consumption at t+1

project instead of the financial markets.

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

$99,000
$25,000 in the project at 20%; consume $85,000 next year.
$85,000
$82,500
With borrowing or lending in the
financial markets, she can achieve any
$55,000 pattern of cash flows she wants—any
of which is better than her original
opportunities.

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

Consumption today
4A-11
Illustrating the Investment Decision - IV
Note that we are better off in that we can
Consumption at t+1

command more consumption today or next year.

$101,500 $101,500 = $15,000×(1.10) + $85,000
$99,000
$85,000
$82,500

$55,000

$85,000
$92,273 = $15,000 +
(1.10)

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

Consumption today
4A-12
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.

Copyright © 2019 McGraw-Hill Education. All rights reserved.

No reproduction or distribution without the prior written consent of McGraw-Hill Education.
4A-13
Quick Quiz
 What factors determine our consumption next year?
 How do investment opportunities create value?

Copyright © 2019 McGraw-Hill Education. All rights reserved.

No reproduction or distribution without the prior written consent of McGraw-Hill Education.
4A-14