Appendix

4A
Net Present Value: First Principles of Finance

Copyright © 2015 by the McGraw-Hill Education (Asia). All rights reserved.

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

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

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.

4A-4
Intertemporal Consumption Opportunity Set
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
$40,000 now; invest the remaining
$80,000
$55,000; consume $60,500 next year.
$60,000
$60,500  $55,000  (1.10) 1

$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
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  (1.10)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
 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.
$30,000
Cash inflows
0
Time
1
Cash outflows
-$25,000
4A-9
Illustrating the Investment Decision
One choice available is to consume
Consumption at t+1

$15,000 now; invest the remaining

$25,000 in the financial markets at
$99,000
10%; 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
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
$99,000 remaining $25,000 in the project at 20%; consume
$85,000 $85,000 next year.
$82,500
With borrowing or lending in the
financial markets, she can achieve
$55,000
any 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
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.

4A-13
Quick Quiz
 What factors determine our consumption next
year?
 How do investment opportunities create
value?

4A-14