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Ross7e ch04appendix

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  • The point at which the intertemporal opportunity set pivots depends upon where your endowment is when interest rates change. If the person had $95,000 in current consumption and no future consumption, the pivot would have been at the x -axis intercept. Such a pivot
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    • 1. CHAPTER 4A Net Present Value: First Principles of Finance
    • 2. Outline
      • Making Consumption Choices Over Time
      • Making Investment Choices Over Time
      • Illustrating the Investment Decision
    • 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.
    • 4. Intertemporal Consumption Opportunity Set A person with $95,000 who faces a 10% interest rate has the following opportunity set. One choice available is to consume $40,000 now; invest the remaining $55,000; consume $60,500 next year. $0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000 Consumption today $0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000 Consumption at t+1
    • 5. Intertemporal Consumption Opportunity Set Another choice available is to consume $60,000 now; invest the remaining $35,000; consume $38,500 next year . $0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000 $0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000 Consumption today Consumption at t+1
    • 6. Taking Advantage of Our Opportunities A person’s preferences will tend to decide where on the opportunity set they will choose to be. $0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000 $0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000 Consumption today Consumption at t+1 Ms. Patience Ms. Impatience
    • 7. Changing Our Opportunities A rise in interest rates will make saving more attractive … … and borrowing less attractive. $0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000 $0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000 Consumption today Consumption at t+1 Consider an investor who has chosen to consume $40,000 now and to consume $60,000 next year.
    • 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 he faces a 10-percent interest rate and is offered the following investment.
      Cash inflows Time Cash outflows 0 1 -$25,000 $30,000
    • 9. Illustrating the Investment Decision Our investor begins with the following opportunity set: endowment of $40,000 today, $55,000 next year and a 10% interest rate. One choice available is to consume $15,000 now; invest the remaining $25,000 in the financial markets at 10%; consume $82,500 next year. $0 Consumption today $0 $99,000 Consumption at t+1 $90,000 $55,000 $82,500 $40,000 $15,000
    • 10. Illustrating the Investment Decision A better alternative would be to invest in the project instead of the financial markets. He could consume $15,000 now; invest the remaining $25,000 in the project at 20%; consume $85,000 next year. $0 Consumption today $0 $99,000 Consumption at t+1 $90,000 With borrowing or lending in the financial markets, he can achieve any pattern of cash flows he wants—any of which is better than his original opportunities. $55,000 $82,500 $40,000 $85,000 $15,000
    • 11. Illustrating the Investment Decision Note that we are better off in that we can command more consumption today or next year. $0 Consumption today $0 $99,000 Consumption at t+1 $101,500 $101,500 = $15,000 ×(1.10) + $85,000 $90,000 $92,273 $55,000 $82,500 $40,000 $85,000 $15,000 $92,273 = $15,000 +

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