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Net Present Value: First Principles of Finance

Net Present Value: First Principles of Finance. What role do Financial Markets play in Investment and Financing decisions?. Financial Marketplace. Anonymous Financial Markets allow individuals/corporations with differing consumption choices to economically coexist

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Net Present Value: First Principles of Finance

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  1. Net Present Value: First Principles of Finance What role do Financial Markets play in Investment and Financing decisions?

  2. Financial Marketplace • Anonymous Financial Markets • allow individuals/corporations with differing consumption choices to economically coexist • create financial instruments at prevailing market clearing rate Chhachhi/519/Ch. 4A

  3. E.g., of Intertemporal Consumption Opportunities • e.g., Current income: $40,000 Next year’s income: $60,000 • I/Rs = 15% • What is the maximum I can consume this year? • What is the maximum I can consume next year? • If I want to consume equal amounts @ year? • If I/Rs go up to 20%, what would be my most likely consumption response? Chhachhi/519/Ch. 4A

  4. $82,500 $55,000 $40,000 $15,000 Investment Decision 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. $99,000 Our investor begins with the following opportunity set: endowment of $40,000 today, $55,000 next year and a 10% interest rate. Consumption at t+1 $0 $0 Consumption today $90,000 Chhachhi/519/Ch. 4A

  5. $85,000 $82,500 With borrowing or lending in the financial markets, he can achieve any pattern of cash flows he wants—any of which is better $55,000 than his original opportunities. $40,000 $15,000 Investment Decision-- Contd. 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. $99,000 Consumption at t+1 $0 $0 $90,000 Consumption today Chhachhi/519/Ch. 4A

  6. $82,500 $85,000 $55,000 $40,000 $15,000 Investment Decision-- Contd. Note that we are better off in that we can command more consumption today or next year. $101,500 $101,500 = $15,000×(1.10) + $85,000 $99,000 $92,273 = $15,000 + $85,000÷(1.10) Consumption at t+1 $0 $0 Consumption today $90,000 $92,273 Chhachhi/519/Ch. 4A

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