4A-0

CHAPTER
4A
Net Present Value:
First Principles of Finance

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Outline
Making Consumption Choices Over Time
Making Investment Choices Over Time
Illustrating the Investment Decision

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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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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.
One choice available is to consume
$100,000
$40,000 now; invest the remaining
$80,000 $55,000; consume $60,500 next year.
$60,500 $55,000 (1.10)1
$60,000

$40,000

$20,000

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

Consumption today
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Intertemporal Consumption
Opportunity Set

Consumption at t+1
Another choice available
$120,000
is to consume $60,000
$100,000 now; invest the remaining
$35,000; consume
$80,000
$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
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Taking Advantage of Our Opportunities

A persons preferences will tend
Consumption at t+1
to decide where on the
$120,000 opportunity set they will choose
to be.
$100,000
Ms. Patience
$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
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Changing Our Opportunities

Consider an investor who has chosen

Consumption at t+1
to consume $40,000 now and to
$120,000 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
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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 he faces a 10-percent interest rate
and is offered the following investment.
$30,000
Cash inflows
0
Time
1
Cash outflows
-$25,000
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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
10%; consume $82,500 next year.
$99,000
Our investor begins with the
$82,500
following opportunity set:
endowment of $40,000
$55,000
today, $55,000 next year
and a 10% interest rate.

$0
$0 $15,000 $40,000 $90,000
Consumption today
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Illustrating the Investment Decision

A better alternative would be to invest in the project
instead of the financial markets.

Consumption at t+1
He could consume $15,000 now; invest the
remaining $25,000 in the project at 20%;
$99,000 consume $85,000 next year.
$85,000
$82,500
With borrowing or lending in
the financial markets, he can
achieve any pattern of cash
$55,000
flows he wantsany of which
is better than his original
opportunities.

$0
$0 $15,000 $40,000 $90,000
Consumption today
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4A-10

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
(1.10)

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