Chapter 16-Investment

Part III
Applications & Extensions

• Investments / choices over
time (Ch 16)
• Uncertainty (Ch 17)
• Externalities & public goods

(Ch 18)
Copyright ©2016 Pearson Education, Ltd. All rights reserved. 16-1

Chapter 16
Interest Rates,
Investments, and
Capital Markets
Topics
• Comparing money today to money in the
future.
• Choices over time.
• Exhaustible resources.(will not be covered)
• Capital markets, interest rates, and
investments.
→ Intertemporal economic decisions: choices
now have costs & benefits in future

Introductory Definitions
• Stock - a quantity or value that is

measured independently of time.
• Flow - a quantity or value that is measured
per unit of time.

Interest Rates
• Interest rate - the percentage more that

must be repaid to borrow money for a fixed
period of time.
• Time value of money: money today is worth

more than money in the future.
– Why?
– Not just because of inflation!

Interest rates
• Assume that you are owed R1000. Would you
prefer to be repaid the R1000 today or receive it
in a year’s time? Why?
• People tend to have positive time preferences

for money. In other words, a Rand received
today is preferred to a Rand received at
some future date.
• Opportunity cost
• Risk
• Inflation
• Interest charges paid by borrowers compensate

lenders for the time value of money.

• In reality, at any point in time there are many
interest rates in an economy. Why?
• Interest rates vary due to:
• Borrow or saving
• Short-term or long-term transaction
• Source of transaction, e.g. bank / credit
card / moneylender
• The creditworthiness of the borrower.
• Etc.
• To simplify, assume that there is a single

interest rate (i).
Discount Rate
• Even when faced with the same interest

rate, responses of people differ: some
borrow, some save.
• Discount rate - a rate reflecting the

relative value an individual places on future
consumption compared to current
consumption.
• The higher the personal discount rate, the

more an individual values present over
future consumption.

Discount Rate cont’d
• If your discount rate is nearly zero
– you would gladly lend money in exchange for a
positive interest rate.
• If your discount rate is high

– you would be willing to borrow at a lower interest
rate.
• If d > i, person will borrow (i.e. forego future

consumption to increase current consumption)
• If d < i, person will save (i.e. forego current

consumption to increase future consumption)
When you save money, you expect to have more in the
bank at the end of the year than you deposited at the
beginning …
… and when you borrow money you are expected to
pay back more than you initially borrowed.
• How much more depends on the interest rate (i).
• E.g. if i = 4% per annum on savings, then for each
Rand you invest at the beginning of the year, you will
have R1x(1+i) = R1x(1+0.04) = R1.04 after 1 year.
• If you leave your R100 in the bank indefinitely and the

interest rate remains constant, you will receive a
payment of R4 each year.
– So you can convert your R100 stock into a flow of
R4-a-year payments forever.

Compounding cont’d
• But if you leave both your R100 and your R4
interest in the bank, the bank must pay you
interest on R104 at end of the second year.
• The bank owes you interest of R4 on your original
deposit of R100, and interest of R4 × 0.04 = R0.16
on your interest from the first year, for a total of
R4.16.
• So after 2 years, the account will have a balance of
R104x(1+0.04) = R108.16.
• Note that in year 2 you earn interest on the initial
deposit plus interest on the first year’s interest
income. This is referred to as compounding interest
over time.

Compounding cont’d
• Thus, at the end of Year 1, your account

contains
$104.00  $100  1.04  $100 1.041
• By the end of Year 2, you have

2
$108.16  $104  1.04  $100 1.04
• At the end of Year 3, your account has

3
$112.49  $108.16  1.04  $100  1.04
• And extending to t years…

Assuming that interest is calculated on an annual
basis, the value of 1 Rand invested now at an
interest rate of i% per year for a period of t years is:
Future Value = R1(1 + i)t
Where, i = annual interest rate

t = no of years.
(1+i)t = compound factor

Frequency of Compounding
• To get the highest return on your savings

account, you need to check both the interest
rate and the frequency of compounding.
• Many banks pay interest more frequently

than once a year.

(cont.)
• If a bank’s annual interest rate is i = 4%,
but it pays interest two times a year,
– The bank pays you half a year’s interest,
i/2 = 2%, after six months.
– For every Rand in your account, the bank pays
you (1 + i/2) = R1.02 after six months.
• At the end of the year,
– the bank owes you (1 + i/2) × (1 + i/2) =
(1 + i/2)2 = (1.02)2 = R1.0404, which is your
original R1 plus 4.04c in interest.
And extending this…

If interest is calculated more frequently (n times per year),
then the value of 1 Rand invested now at an interest rate of
i% per year for a period of t years is:
Future Value = R1*(1 + i/n)tn
Where, i = annual interest rate

t = number of years.
n = number of conversion periods per year
(1+i/n)tn = compound factor
See Table 16.1 for examples of such calculations

Table 16.1 Interest and the

Using Interest Rates to Connect
the Present and Future
• Present value (PV) - the value of the
money you put in the bank today.
• Future value (FV) - the present value
plus interest.
• If you deposit PV dollars in the bank today
and allow the interest to compound for t
years, how much money will you have at the
end?

Using Interest Rates to Connect the
Present and Future
• If we know the present value (PV) of an
investment, we can compute its future value
(FV) after t years using the following formula:
t
FV  PV (1  i)
where:
i = interest rate per year
t = no. of years
(1 + i)t = compound factor

PV & FV cont’d
t
FV  PV (1  i)
So e.g. R1 in the bank for 50 years, at 1%

compounded annually = R1.64
• at 4% = R7.11
• at 10% = 117.39
• at 20% = R9100.44!
See Table 16.2 for more examples of such

calculations.

Table 16.2 future value, FV, to which $1
grows by the end of year t at various
interest rates, i, compounded annually, $

Present Value
• If we want to have FV = R100 at the end of

a year and the interest rate is i = 4%, then:
PV × 1.04 = R100.
• Dividing both sides of this expression by
1.04,
PV = R100/1.04 = R96.15
• R96.15 is needed in the bank today to have
R100 next year.

• General formula for computing present values
from future values i.e. relating money t periods
in the future to money today:
FV -t
PV  t
= FV (1 + i)
(1 + i)
where:
(1 + i)-t = discount factor
• E.g. using a discount rate of 4% per annum, the

present value of a promise of R1000 in 1 year’s
time is:
R1000x(1+0.04)-1 = R1000x0.96154 = R961.54

Table 16.3 present value, PV, of a payment
of $1 at the end of year t at various interest
rates, i, compounded annually, $

Figure 16.1 PV of $1 in the future
$1
i = 0%
90¢
If i = 0%, a promise of 1$ 10 years from now has a PV
80¢ of 1$
Present value of 1 $
70¢
If i = 5%, a promise of 1$ 10 years from now has a
60¢
PV of 61.4 cents
50¢ If i = 10%, a promise of 1$ 10 years from now has

a PV of 38.6 cents
40¢
If i = 20%, a promise of 1$ 10 years from
30¢ now has a PV of 16.15 cents
20¢
10¢ i = 20% i = 10% i = 5%
0 10 20 30 40 50 60 70 80 90 100
t, Years
Stream of Payments
• Sometimes we need to deal with payments

per period, which are flow measures, rather
than a present value or future value, which
are stock measures.

Payments for a finite number of
years
• Suppose that you agree to pay $10 at the
end of each year for three years to repay
a debt.
• If the interest rate is 10%, the present
value of this series of payments is:
$10 $10 $10

PV   2  3  $24.87
1.1 1.1 1.1

Payments for a finite number of
years cont’d
 Add up the present value of each

payment to determine the PV of a series
of future payments.
 If P1 = P2 = … = PT = f, then the stream

of payments is an annuity.

Payments for a Finite Number of
Years (cont’d)
• If you make a future payment of f per
year for t years at an interest rate of i,
the present value (stock) of this flow of
payments (annuity) is
 1 1 1 
PV  f    t 
 1  i  1  i  1  i  
1 2
PV = f [(1 + i)-1 + (1 + i)-2 + . . . + (1 + i)-t]

PV = f [USPVi,t] (uniform series PV)
Table 16.4 Present Value, PV, of a Flow of
$10 a Year for t Years at Various Interest
Rates, i, Compounded Annually, $

 Example: A soccer coach is offered R1 million per year
(paid at the end of the year) for a period of three years to
coach a team. What is the present value of his contract?
Assume a discount rate of 12% per annum.
Payment Nominal Present Value

Value
1 R1 million R1m*(1+0.12)-1 = R0.893m
2 R1 million R1m*(1+0.12)-2 = R0.797m
3 R1 million R1m*(1+0.12)-3 = R0.712m
Total R3 million R2.402m
PV = R1million * [USPV12%, 3 Years]

= R1million * [(1+0.12)-1 + (1+0.12)-2 + (1+0.12)-3]
= R1million * [2.4018] = R2.4018 million
Solved Problem 16.1
 Melody Toyota advertises that it will sell you a Corolla for
$14,000 or lease it to you. To lease it, you must make a
down payment of $1,650 and agree to pay $1,800 at the
end of each of the next two years. After the last lease
payment, you may buy the car for $12,000. If you plan to
keep the car until it falls apart (at least a decade) and the
interest rate is 10%, which approach has a lower present
value of costs?
Option 1: Purchase Option 2: Lease
t Payment PV t Payment PV
0 $14000 $14000 0 $1650 $1650
1 1 $1800 $1636
2 2 $1800 + $11405
$12000
Total $14000 Total $14691
Payments forever (perpetuity)
• If you put PV dollars into a bank account

earning an interest rate of i,
– you can get an interest or future
payment of f = i × PV at the end of the
year.
• To get a payment of f each year forever,
you’d have to put in the bank:
f
PV 
i
Future value of payments over
time
• Suppose that you want to know how much
you’ll have in your savings account, FV, at
some future time if you save f each year.
• At the end of t years, the account has:
FV = f [1 + (1 + i)1 + (1 + i)2 + . . . + (1 + i) t − 1]

Inflation and Discounting
• Nominal prices - actual prices that are not

adjusted for inflation – rise over time.
• Real prices - constant prices that are
independent of inflation.

Adjusting for Inflation
• Suppose that the annual rate of inflation is γ
(“gamma”). If the current price of a good if
f, then its price one year from now will be:
~
f  f (1   )
~
• Therefore, if γ = 10%, a nominal f
payment
~
of f one year from today has a real value
(measured in today’s Rands) of:
~ 1
~
1
~
f  f (1   )  f (1  0.10)  0.909 f
Nominal & real rates of interest
• Without inflation, R1 one year from today has a PV
of R1/(1 + i) today.
• With an inflation rate of γ, R1 one year from today

has a PV of R1/[(1 + i)(1 + γ)].
• E.g. if i = 5% and γ = 10%, R100 one year from today

is worth R100/[(1.05 )× (1.1)] = R86.58 today.
Likewise, R100 today is worth

R100×(1.05)×(1.1) = R115.50 nominal Rands
one year from today.

Nominal & real int rates cont’d
~
• Banks pay a nominal interest rate, i , rather
than a real one.
• If they’re going to get people whose real

discount rate is i to save, banks’ nominal
interest rate must be such that
~
(1  i )  (1  i )(1   )  1  i  i  
• Therefore, the nominal rate is
~
i  i  i  
~
i  i   if  and i are low
Nominal & real int rates cont’d
• Rearranging the previous equation, we see
that: ~
i
i
1 
• Therefore, to obtain the real present value of

a payment one year from now we use:
~ ~
f f f
PV    ~
1  i (1   )(1  i ) (1  i )
Choices over Time
• Often decisions made by consumers and
firms involve comparisons over time.
• One way to make a choice involving time is

to pick the option with the highest present
value.

Investing
• A firm makes an investment if the expected

return from the investment is greater than
the opportunity cost.
• The opportunity cost is the best alternative

use of its money, which is what it would
earn in the next best use of the money.

Net Present Value Approach
• A firm has to decide whether to buy a truck

for $20,000.
A firm should make an investment only if

the present value of the expected return
exceeds the present value of the costs.

NPV Approach (cont.)
• If
R = the present value of the expected returns to an
investment and
C = the present value of the costs of the
investment,
the firm should make the investment if R > C.
• A firm should make an investment only if the net

present value is positive:
NPV = R − C > 0.

• The initial year is t = 0, the firm’s revenue in year
t is Rt, and its cost in year t is Ct.
• If the last year in which either revenue or cost is
nonzero is T, the net present value rule holds
that the firm should invest if
NPV  R  C
 R1 R2 RT 
  R0    ...  T 
1  i  1  i  1  i  
1 2

 C1 C2 CT 
 C0    ...  T 
 0.
1  i  1  i  1  i  
1 2


• Alternatively we could examine whether the
present value of the cash flow in each year
πt = Rt − Ct is positive.
R1  C1 R2  C2 RT  CT
NPV   R0  C0     ... 
1  i  1  i  1  i 
1 2 T
1 2 T
 0    ...   0.
1  i  1  i  1  i 
1 2 T
Note: The discount rate, i, used in NPV calculations

should reflect the firm’s opportunity cost of capital.
If NPV > 0, then the investment is more profitable
than the opportunity cost.
Solved Problem 16.2
Peter Guber and Joe Lacob bought the Golden State

Warriors basketball team for $450 million in 2010.
Forbes magazine estimates the team’s net income for
2009 was $11.9 million.
If the new owners believed that they would continue
to earn this annual profit (after adjusting for
inflation), f = $11.9 million, forever, was this
investment more lucrative than putting the $450
million in a savings account that pays a real interest
rate of i = 2%? At i = 3%?

Solved Problem 16.2: Answer
Determine the net present value of the team.

Given a real interest rate of 2%:
PV of the stream of income = $11.9m/0.02 = $595m;
PV of the cost = the purchase price of $450m
NPV = $595m - $450m = $145m > 0 .
However, for interest rate 3%:

PV of income stream = $11.9m/0.03 = $397m
NPV = $397m - $450m = -$53 million < 0 .

Internal Rate of Return Approach
• Internal rate of return (irr) - the

discount rate that results in a net present
value of an investment of zero
• i.e. the discount rate (rate of return) at
which a firm is indifferent between making
an investment or not.
1 2 T
NPV   0    ...  0
1  irr 1  irr 2
1  irr 
T

Internal Rate of Return
Approach (cont.)
• The investment’s rate of return is found

by rearranging the previous equation
and replacing i with irr:
f
PV 
i
f
irr  .
PV
Internal Rate of Return
Approach (cont.)
• If the firm is borrowing money to make the
investment, it pays for the firm to borrow to
make the investment if the internal rate of
return on that investment exceeds that of the
next best alternative: irr > i.
• If the firm is investing equity capital to make the

investment, it pays for the firm to use equity
capital only if the internal rate of return on
that investment exceeds that of the next best
alternative: irr > i.

IRR - example
• A new solar geyser will cost you R10000.

You estimate that it will save you R1000 a
year, forever. What is the irr on this
investment? Should you buy the panel?
• Irr = f/PV = 1000 / 10000 = 10%
• Buy it? If the market interest rate is < 10%

Solved Problem 16.3
• Peter Guber and Joe Lacob can buy the

Golden State Warriors basketball team for
$450 million, and they expect an annual real
flow of payments (profits) of f = $11.9
million forever. Using the internal rate of
return approach, should they buy the team
if the real interest rate is 2%?

• Determine the internal rate of return to this

investment and compare it to the interest
rate. Calculate that the internal rate of
return from buying the Warriors is
f $11 .9million
irr    2.6%
PV $450million
• Because this irr, 2.6%, is greater than the
real interest rate, 2%, they buy the team .

Rate of Return on Bonds
• Bond - a piece of paper issued by a
government or a corporation that promises
to repay the borrower with a payment
stream (fixed regular payment amount).
• Face value – the amount borrowed.
• Maturity date – when the borrower will
redeem the bond by repaying face value.
• Perpetuities – bonds with no maturity date
(the face value is never returned).
• If nominal interest rates rise, bond
prices fall (to keep the rate of return in line
with market rates).

Capital Markets, Interest Rates,
and Investments
• The intersection of supply of and demand for
loanable funds determines the equilibrium
price or interest rate and the equilibrium
quantity of funds in this capital market.
• DD: for investment funds from indivs, firms,
and govt;
• SS: savings from indivs & firms
• ‘Shift variables’ can change eqm as usual…

Figure 16.4 Capital Market
Equilibrium

Solved Problem 16.4
• Suppose the government needs to borrow

money to pay for fighting a war in a foreign
land. Show that increased borrowing by the
government—an increase in the
government’s demand for money at any
given interest rate—raises the equilibrium
interest rate, which discourages or crowds
out private investment.


Human capital investment decision
(or, should you attend university?
Decision: invest in education to increase productivity
& future earnings?
e.g. decision to attend university

Assume: want to max lifetime earnings.
Simplify – choose:
• start work straight after matric, work from 18 – 70
(benefits = income)
• start university straight after matric, graduate in 4
years, work from 22-70
(benefits = income after 22;
costs = tuition fees + foregone earnings
i.e. opportunity cost).
Challenge solution: should you
go to college?

Human capital cont’d
The figure (Challenge Solution) shows costs &
benefits for ‘average’ USA high school diplomate vs
college (= university) graduate at each age.
NPV is positive (PV benefits of college > PV costs) for

discount rates < 10.42% in USA.

Note PV depends on discount rate applied: Table
(average irr to univ education = 10.42% in USA)

Challenge solution should you
go to college? (Cont.)

Human capital cont’d
South Africa: no comparable study BUT there is

evidence of high returns to university education in
terms of employability:
• graduates find jobs much faster (Moleke, 2005)
• & are less likely to be unemployed (Broekhuizen &
van der Berg 2013)
– see Returns to studying on moodle fyi.

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Part III

Applications & Extensions

• Uncertainty (Ch 17)

• Externalities & public goods

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 16-1

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 16-3

• Stock - a quantity or value that is

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 16-4

• Interest rate - the percentage more that

• Time value of money: money today is worth

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 16-5

• People tend to have positive time preferences

• Interest charges paid by borrowers compensate

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 16-6

• Interest rates vary due to:

• To simplify, assume that there is a single

• Even when faced with the same interest

• Discount rate - a rate reflecting the

• The higher the personal discount rate, the

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 16-8

• If your discount rate is high

• If d > i, person will borrow (i.e. forego future

• If d < i, person will save (i.e. forego current

• If you leave your R100 in the bank indefinitely and the

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 16-10

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 16-11

• Thus, at the end of Year 1, your account

• By the end of Year 2, you have

• At the end of Year 3, your account has

• And extending to t years…

Future Value = R1(1 + i)t

Where, i = annual interest rate

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 16-13

• To get the highest return on your savings

• Many banks pay interest more frequently

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Copyright ©2016 Pearson Education, Ltd. All rights reserved. 16-15

Future Value = R1*(1 + i/n)tn

Where, i = annual interest rate

See Table 16.1 for examples of such calculations

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Copyright ©2016 Pearson Education, Ltd. All rights reserved. 16-17

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Copyright ©2016 Pearson Education, Ltd. All rights reserved. 16-19

So e.g. R1 in the bank for 50 years, at 1%

See Table 16.2 for more examples of such

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Copyright ©2016 Pearson Education, Ltd. All rights reserved. 16-21

• If we want to have FV = R100 at the end of

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 16-23

• E.g. using a discount rate of 4% per annum, the

R1000x(1+0.04)-1 = R1000x0.96154 = R961.54

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 16-24

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 16-25

50¢ If i = 10%, a promise of 1$ 10 years from now has

10¢ i = 20% i = 10% i = 5%

• Sometimes we need to deal with payments

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$10 $10 $10

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 Add up the present value of each

 If P1 = P2 = … = PT = f, then the stream

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 16-29

PV = f [(1 + i)-1 + (1 + i)-2 + . . . + (1 + i)-t]