Chapter 15 Investment, Time, and Capital Markets: Teaching Notes

Chapter 15: Investment, Time and Capital Markets
CHAPTER 15
INVESTMENT, TIME, AND CAPITAL MARKETS
TEACHING NOTES
The primary focus of this chapter is on how firms make capital investment decisions, though
the chapter also includes some topical applications of the net present value criterion. The key sections
to cover are 15.1, 15.2, and 15.4 which cover stocks and flows, present discounted value, and the net
present value criterion respectively. You can then pick and choose between the remaining sections
depending on your time constraint and interest in the subject. Each of the special topics is briefly
described below.
Students will find NPV to be one of the most powerful tools of the course. You will notice that
this chapter does not derive the rate of time preference; instead, it introduces students to financial
decisionmaking. Students should have no problem comprehending the tradeoff between
consumption today and consumption tomorrow, but they may still have problems with (1 + R) as the
price of today’s consumption. Emphasize the opportunity cost interpretation of this price. Human
capital theory is a topic that bridges Chapters 14 and 15. Interesting issues for discussion include the
relationship between wages and education and the return on education. If students understand
present value, mastering the NPV criterion is easy. However, applying the NPV rule is more difficult.
Section 15.3 extends the discussion of present and future values by exploring the connection
between the value of a bond and perpetuities. If students understand the effective yield on a bond,
you can introduce the internal rate of return, IRR, and then discuss why the net present value, NPV,
is superior to the IRR criterion. For a comparison of IRR and NPV, see Brealey and Myers, Principles
of Corporate Finance (McGrawHill, 1988).
Section 15.5 discusses risk and the riskfree discount rate. You can motivate the discussion of
risk by considering the probability of default by different classes of borrowers (this introduces the
discussion of the credit market that will take place in Section 17.1). This section introduces students
to the Capital Asset Pricing Model. To understand the CAPM model, students need to be familiar
with Chapter 5, particularly Section 5.4, “The Demand for Risky Assets.” The biggest stumbling block
is the definition of . If students have an intuitive feel for , they may use Equation (15.7) to calculate
a firm’s discount rate.
Section 15.6, applies the NPV criterion to consumer decisions, leading to a wealth of
applications. Example 15.4 presents Hausman’s analysis of the decision to purchase an air
conditioner. Discuss whether the results of this study are reasonable.
Section 15.7 discusses depletable resources and presents Hotelling’s model of exhaustible
resources. This example is a particularly good topic for class discussion when oil prices are rising.
During other periods, you may need to motivate the analysis. For another example, see the problem
of cutting timber in Chiang, Fundamental Methods of Mathematical Economics (McGrawHill, 1984)
pp. 300301. Note that these problems involve calculus but may be solved geometrically.
Section 15.8 examines the market for loanable funds. If you have introduced students to the
marginal rate of time preference, you can complete the analysis by introducing the investment
spending frontier, similar to the productionpossibilities frontier in Section 7.5 (see Figure 7.10). The
investment frontier shows the rate at which consumption today may be transformed into consumption
tomorrow. By superimposing indifference curves onto the frontier, you may show the individual’s
optimal consumption today and tomorrow. This analysis may be extended by discussing borrowing
and lending and will serve as an introduction to the analysis of efficiency in Chapter 16.
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REVIEW QUESTIONS
1. A firm uses cloth and labor to produce shirts in a factory that it bought for $10 million.
Which of its factor inputs are measured as flows and which as stocks? How would your
answer change if the firm had leased a factory instead of buying one? Is its output
measured as a flow or a stock? What about profit?
Inputs measured in units per time period are flows: how much is used during an hour,
day, week, month, or year? Inputs measured in units at points in time are stocks:
how much is available during the entire production period? Thus, cloth and labor are
measured as service flows, while capital embodied in the factory is measured as a
stock. Note that services flow from the capital stock over time. Furthermore, the
depreciation on the capital stock is a flow. Leasing the factory implies a flow of
payments to the owner of the factory, but the capital stock itself does not change with
time. Output flows from the production process. During each period, management
sells the shirts and pays for the factors of production. Profit is a residual cash flow.
2. Suppose the interest rate is 10 percent. If $100 is invested at this rate today, how much
will it be worth after one year? After two years? After five years? What is the value today
of $100 paid one year from now? Paid two years from now? Paid five years from now?
We would like to know the future value, FV, of $100 invested today at an interest rate
of 10 percent. One year from now our investment will be equal to
FV = $100 + ($100)(10%) = $110.
Two years from now we will earn interest on the $100 ($10) and we will earn interest
on the interest from the first year, i.e., ($10)(10%) = $1. Thus, our investment will be
worth $100 + $10 (from the first year) + $10 (from the second year) + $1 (interest on
the first year’s interest) = $121.
Algebraically, FV = PDV(1 + R)t, where PDV is the present discounted value of the

investment, R is the interest rate, and t is the number of years. After two years,
FV = PDV(1 + R)t = ($100)(1.1)2 = ($100)(1.21) = $121.00.
After five years
FV = PDV(1 + R)t = ($100)(1.1)5 = ($100)(1.61051) = $161.05.
To find the present discounted value of $100 paid one year from now, we ask how
much is needed to invest today at 10 percent to have $100 one year from now. Using
our formula, we solve for PDV as a function of FV:
PDV = (FV)(1 + R)t.
With t = 1, R = 0.10, and FV = $100,
PDV = (100)(1.1)1 = $90.91.
With t = 2, PDV = (1.1)2 = $82.64,
With t = 5, PDV = (1.1)5 = $62.09.
3. You are offered the choice of two payment streams: (a) $100 paid one year from now and
$100 paid two years from now; (b) $80 paid one year from now and $130 paid two years
from now. Which payment stream would you prefer if the interest rate is 5 percent? If it is
15 percent?
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To compare two income streams, we calculate the present discounted value of each
and choose the stream with the highest present discounted value. We use the formula
PDV = FV(1 + R)t for each cash flow. See Exercise (2) above. Stream (a) has two
payments:
PDVa = FV1(1 + R)1 + FV2(1 + R)2
PDVa = ($100)(1.05)1 + ($100)(1.05)2, or
PDVa = $95.24 + 90.70 = $185.94.
Stream (b) has two payments:
PDVb = ($80)(1.05)1 + ($130)(1.05)2, or
PDVb = $76.19 + $117.91 = $194.10.
At an interest rate of 5 percent, you should select (b).
If the interest rate is 15 percent, the present discounted values of the two income
streams would be:
PDVa = ($100)(1.15)1 + ($100)(1.15)2, or
PDVa = $89.96 + $75.61 = $162.57, and
PDVb = ($80)(1.15)1 + ($130)(1.15)2, or
PDVb = $69.57 + $98.30 = $167.87.
You should still select (b).
4. How do investors calculate the present value of a bond? If the interest rate is 5 percent,
what is the present value of a perpetuity that pays $1,000 per year forever?
The present value of a bond is the sum of discounted values of each payment to the
bond holder over the life of the bond. This involves the payment of interest in each
period and then the repayment of the principal at the end of the bond’s life. A
perpetuity involves paying the interest in every future period and no repayment of the
A
principal. The present discounted value of a perpetuity is PDV  , where A is the
R
annual payment and R is the annual interest rate. If A = $1,000 and R = 0.05,
$1,000
PDV   $20,000 .
0.05
5. What is the effective yield on a bond? How does one calculate it? Why do some
corporate bonds have higher effective yields than others?
The effective yield is the interest rate that equates the present value of a bond’s
payment stream with the bond’s market price. The present discounted value of a
payment made in the future is
PDV = FV(1 + R)t,
where t is the length of time before payment. The bond’s selling price is its PDV. The
payments it makes are the future values, FV, paid in time t. Thus, we must solve for
R, which is the bond’s effective yield. The effective yield is determined by the
interaction of buyers and sellers in the bond market. As the riskiness of the issuing
firm increases, buyers must be rewarded with a higher rate of return. Higher rates of
return imply a lower present discounted value. If bonds have the same coupon
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payments, the bonds of the riskiest firms will sell for less than the bonds of the less
risky firms.
6. What is the Net Present Value (NPV) criterion for investment decisions? How does one
calculate the NPV of an investment project? If all cash flows for a project are certain,
what discount rate should be used to calculate NPV?
The Net Present Value criterion for investment decisions is “invest if the present value
of the expected future cash flows from the investment is larger than the cost of the
investment” (Section 15.4). We calculate the NPV by (1) determining the present
discounted value of all future cash flows and (2) subtracting the discounted value of all
costs, present and future. To discount both income and cost, the firm should use a
discount rate that reflects its opportunity cost of capital, the next highest return on an
alternative investment of similar riskiness. Therefore, the riskfree interest rate
should be used if the cash flows are certain.
7. What is the difference between a real discount rate and a nominal discount rate? When
should a real discount rate be used in an NPV calculation and when should a nominal rate
be used?
The real discount rate is net of inflation, whereas the nominal discount rate includes
inflationary expectations. The real discount rate is equal to the nominal discount rate
minus the rate of inflation. If cash flows are in real terms, the appropriate discount
rate is the nominal rate. For example, in applying the NPV criterion to a
manufacturing decision, if future prices of inputs and outputs are not adjusted for
inflation (which they often are not), a real discount rate should be used to determine
whether the NPV is positive.
8. How is a risk premium used to account for risk in NPV calculations? What is the
difference between diversifiable and nondiversifiable risk? Why should only
nondiversifiable risk enter into the risk premium?
To determine the present discounted value of a cash flow, the discount rate should
reflect the riskiness of the project generating the cash flow. The risk premium is the
difference between a discount rate that reflects the riskiness of the cash flow and a
discount rate on a riskfree flow, e.g., the discount rate associated with a shortterm
government bond. The higher the riskiness of a project, the higher the risk premium.
Diversifiable risk can be eliminated by investing in many projects. Hence, an efficient
capital market will not compensate an investor for taking on risk that can be
eliminated costlessly. Nondiversifiable risk is that part of a project’s risk that cannot
be eliminated by investing in a large number of other projects. It is that part of a
project’s risk which is correlated with the portfolio of all projects available in the
market. Since investors can eliminate diversifiable risk, they cannot expect to earn a
risk premium on diversifiable risk.
9. What is meant by the “market return” in the Capital Asset Pricing Model (CAPM)? Why
is the market return greater than the riskfree interest rate? What does an asset’s “beta”
measure in the CAPM? Why should highbeta assets have a higher expected return than
lowbeta assets?
In the Capital Asset Pricing Model (CAPM), the market return is the rate of return on
the portfolio of assets held by the market. The market return reflects nondiversifiable
risk.
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Since the market portfolio has no diversifiable risk, the market return reflects the risk
premium associated with holding one unit of nondiversifiable risk. The market rate of
return is greater than the riskfree rate of return, because riskaverse investors must
be compensated with higher average returns for holding a risky asset.
An asset’s beta reflects the sensitivity (covariance) of the asset’s return with the
return on the market portfolio. An asset with a high beta will have a greater expected
return than a lowbeta asset, since the highbeta asset has greater nondiversifiable
risk than the lowbeta asset.
10. Suppose you are deciding whether to invest $100 million in a steel mill. You know the
expected cash flows for the project, but they are risky steel prices could rise or fall in the
future. How would the CAPM help you select a discount rate for an NPV calculation?
To evaluate the net present value of a $100 million investment in a steel mill, you
should use the stock market’s current evaluation of firms that own steel mills as a
guide to selecting the appropriate discount rate. For example, you would (1) identify
nondiversified steel firms, those that are primarily involved in steel production, (2)
determine the beta associated with stocks issued by those companies (this can be done
statistically or by relying on a financial service that publishes stock betas, such as
Value Line), and (3) take a weighted average of these betas, where the weights are
equal to the firm’s assets divided by the sum of all diversified steel firms’ assets. With
an estimate of beta, plus estimates of the expected market and riskfree rates of
return, you could infer the discount rate using Equation (15.7) in the text: Discount
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rate =
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.
11. How does a consumer trade off current and future costs when selecting an air
conditioner or other major appliance? How could this selection be aided by an NPV
calculation?
The NPV calculation for a durable good involves discounting to the present all future
services from the appliance, as well as any salvage value at the end of the appliance’s
life, and subtracting its cost and the discounted value of any expenses. Discounting is
done at the opportunity cost of money. Of course, this calculation assumes well
defined quantities of future services. If these services are not well defined, the
consumer should ask what value of these services would yield an NPV of zero. If this
value is less than the price that the consumer would be willing to pay in each period,
the investment should be made.
12. What is meant by the “user cost” of producing an exhaustible resource? Why does
price minus extraction cost rise at the rate of interest in a competitive exhaustible
resource market?
In addition to the opportunity cost of extracting the resource and preparing it for sale,
there is an additional opportunity cost arising from the depletion of the resource. User
cost is the difference between price and the marginal cost of production. User cost
rises over time because, as reserves of the resource become depleted, the remaining
reserves become more valuable.
Given constant demand over time, the price of the resource minus its marginal cost of
extraction, P MC, should rise over time at the rate of interest. If P MC rises faster
than the rate of interest, no extraction should occur in the present period, because
holding the resource for another year would earn a higher rate of return than selling
the resource now and investing the proceeds for another year. If P MC rises slower
than the rate of interest, current extraction should increase, thus increasing the
supply at each price, lowering the equilibrium price, and decreasing the return on
producing the resource. In equilibrium, the price of a resource rises at the rate of
interest.
13. What determines the supply of loanable funds? The demand for loanable funds? What
might cause the supply or demand for loanable funds to shift, and how would that affect
interest rates?
The supply of loanable funds is determined by the interest rate offered to savers. A
higher interest rate induces households to consume less today (save) in favor of
greater consumption in the future. The demand for loanable funds comes from
consumers who wish to consume more today than tomorrow or from investors who
wish to borrow money. Demand depends on the interest rate at which these two
groups can borrow. Several factors can shift the demand and supply of loanable funds.
On the one hand, for example, a recession decreases demand at all interest rates,
shifting the demand curve inward and causing the equilibrium interest rate to fall.
On the other hand, the supply of loanable funds will shift out if the Federal Reserve
increases the money supply, again causing the interest rate to fall.
EXERCISES
1. Suppose the interest rate is 10 percent. What is the value of a coupon bond that pays
$80 per year for each of the next five years and then makes a principal repayment of $1,000
in the sixth year? Repeat for an interest rate of 15 percent.
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We need to determine the present discounted value, PDV, of a stream of payments
over the next six years. We translate future values, FV, into the present with the
following formula:
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where R is the interest rate, equal to 10 percent, and t is the number of years in the
future. For example, the present value of the first $80 payment one year from now is
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The value of all coupon payments over five years can be found the same way:
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or
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Finally, we calculate the present value of the final payment of $1,000 in the sixth year:
$1,000 $1,000
PDV  6
  $564.47.
11
. 1.771
Thus, the present value of the bond is $303.26 + $564.47 = $867.73.
With an interest rate of 15 percent, we calculate the value of the bond in the same
way:
PDV = 80(0.870 + 0.756 + 0.658 + 0.572 + 0.497) + (1,000)(0.432), or
PDV = $268.17 + $432.32 = $700.49.
As the interest rate increases, while payments are held constant, the value of the bond
decreases.
2. A bond has two years to mature. It makes a coupon payment of $100 after one year and
both a coupon payment of $100 and a principal repayment of $1,000 after two years. The
bond is selling for $966. What is its effective yield?
We want to know the interest rate that will yield a present value of $966 for an income
stream of $100 after one year and $1,100 after two years. Find i such that
966 = (100)(1 + i)1 + (1,100)(1 + i)2.
Algebraic manipulation yields
966(1 + i)2 = 100(1 + i) + 1,100, or
966 + 1,932i + 966i2 100 100i 1,100 = 0, or
966i2 + 1,832i 234 = 0.
Using the quadratic formula to solve for i,
i = 0.12 or 1.068.
Since 1.068 does not make economic sense, the effective yield is 12 percent.
3. Equation (15.5) shows the net present value of an investment in an electric motor
factory. Half of the $10 million cost is paid initially and the other half after a year. The
factory is expected to lose money during its first two years of operation. If the discount
rate is 4 percent, what is the NPV? Is the investment worthwhile?
Redefining terms, Equation 15.5 becomes
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Calculating the NPV we find:
NPV = 5 4.81 0.92 0.44 + 0.82 + 0.79 + 0.70 + 0.67 + 0.62 + 0.60 + 0.58 + 0.55
+0.53 + 0.51 + 0.49 + 0.47 + 0.46 + 0.44 + 0.46 = 0.337734.
The investment loses $337,734 and is not worthwhile.
4. The market interest rate is 10 percent and is expected to stay at that level. Consumers
can borrow and lend all they want at this rate. Explain your choice in each of the
following situations:
a. Would you prefer a $500 gift today or a $540 gift next year?
The present value of $500 today is $500. The present value of $540 next year is
$540.00
 $490.91.
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.
Therefore, I would prefer the $500 today.
b. Would you prefer a $100 gift now or a $500 loan without interest for four years?
Compare the present value of the interest not paid during four years with $100 today.
The present value of the interest is
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34.15 = $158.49.
Therefore, choose the interestfree loan.
c. Would you prefer a $250 rebate on an $8,000 car or one year of financing for the full
price of the car at 5 percent interest?
The interest rate is 5 percent, which is 5 percent less than the current market rate.
You save $400 = (0.5)($8,000) one year from now. The present value of this $400 is
$400
 $363.64.
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.
This is greater than $250. Therefore, choose the financing.
d. You have just won a million dollar lottery and will receive $50,000 a year for the
next 20 years. How much is this worth to you today?
We must find the net present value of $50,000 a year for the next 20 years:
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e. You win the “honest million” jackpot. You can have $1 million today or $50,000 per
year for eternity (a right that can be passed on to your heirs). Which do you prefer?
The value of the perpetuity is $500,000, which makes it advisable take the million.
f. In the past, adult children had to pay taxes on gifts over $10,000 from their parents,
but parents could loan money to their children interestfree. Why did some people
call this unfair? To whom were the rules unfair?
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Any gift of $N from parent to child could be made without taxation by loaning the
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example, to avoid taxes on a $50,000 gift, the parent would loan the child $550,000, a
suming a 10 percent interest rate. With that money, the child could earn $55,000 in in
erest after one year and still have $500,000 to pay back to the parent. The pr
sent value of $55,000 one year from now is $50,000. People of more moderate incom
s would find these rules unfair: they might onl
5. Ralph is trying to decide whether to go to graduate school. If he spends two years in
graduate school, paying $10,000 tuition each year, he will get a job that will pay $50,000 per
year for the rest of his working life. If he does not go to school, he will go into the work
force immediately. He will then make $20,000 per year for the next three years, $30,000 for
the following three years, and $50,000 per year every year after that. If the interest rate is
10 percent, is graduate school a good financial investment?
Consider Ralph’s income over the next six years, assuming all payments occur at the
end of the year. (After the sixth year, Ralph’s income will be the same with or without
education.) With graduate school, the present value of income for the next six years is
$113,631,
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Without graduate school, the present value of income for the next six years is
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The payoff from graduate school is large enough to justify the foregone income and
tuition expense while Ralph is in school; he should therefore go to school.
6. Suppose your uncle gave you an oil well like the one described in Section 15.7.
(Marginal production cost is constant at $10.) The price of oil is currently $20 but is
controlled by a cartel that accounts for a large fraction of total production. Should you
produce and sell all your oil now or wait to produce? Explain your answer.
If a cartel accounts for a large fraction of total production, today’s price minus
marginal cost, P t MC will rise at a rate less than the rate of interest. This is because
the cartel will choose output such that marginal revenue minus MC rises at the rate of
interest. Since price exceeds marginal revenue, P t MC will rise at a rate less than
the rate of interest. So, to maximize net present value, all oil should be sold today.
The profits should be invested at the rate of interest.
*7. You are planning to invest in fine wine. Each case of wine costs $100, and you know
from experience that the value of a case of wine held for t years is (100)t 1/2. One hundred
cases of wine are available for sale, and the interest rate is 10 percent.
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a. How many cases should you buy, how long should you wait to sell them, and how
much money will you receive at the time of their sale?
Buying a case is a good investment if the net present value is positive. If we buy a
case and sell it after t years, we pay $100 now and receive 100t0.5 when it is sold. The
NPV of this investment is
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If we do buy a case, we will choose t to maximize the NPV. This implies
differentiating with respect to t to obtain the necessary condition that
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d
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By multiplying both sides of the first order condition by e0.1t, we obtain
50t 0.5  10t 0.5  0 , or t = 5.
If we held the case for 5 years, the NPV is
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250
.
Therefore, we should buy a case and hold it for five years, where the value at the time
of sale is ($100)(5 0.5). Since each case is a good investment, we should buy all 100
cases.
Another way to get the same answer is to compare holding the wine to putting your
$100 in the bank. The bank pays interest of 10 percent, while the wine increases in
value at the rate of
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d
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As long as t < 5, the return on wine is greater than or equal to 10 percent. After t = 5,
the return on wine drops below 10 percent. Therefore, t = 5 is the time to switch your
wealth from wine to the bank. As for the issue of whether to buy wine at all, if we put
$100 in the bank, we will have 100e0.5 after five years, whereas if we spend $100 on
wine, we will have 100t 0.5 = (100)(50.5 ), which is greater than 100e0.5 in five years.
b. Suppose that at the time of purchase, someone offers you $130 per case
immediately. Should you take the offer?
You just bought the wine and are offered $130 for resale. You should accept the offer
if the NPV is positive. You get $130 now, but lose the ($100)(5 0.5) you would get for
selling in five years. Thus, the NPV of the offer is
NPV = 130 (e(0.1)(5) )(100)(50.5 ) = 238 < 0.
Therefore, you should not sell.
The other approach to solving this problem is to note that the $130 could be put in the
bank and would grow to
$214.33 = ($130)(e0.5 ),
in five years. This is still less than
$223.61 = ($100)(50.5 ),
the value of the wine after five years.
c. How would your answers change if the interest rate were only 5 percent?
If the interest rate changes from 10 percent to 5 percent, the NPV calculation is
NPV = 100 + (e0.05t )(100)(t0.5 ).
As before, we maximize this expression:
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d
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By multiplying both sides of the first order condition by e0.05t, it becomes
50t0.5 5t0.5 = 0,
or t = 10. If we hold the case 10 years, NPV is
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With a lower interest rate, it pays to hold onto the wine longer before selling it,
because the value of the wine is increasing at the same rate as before. Again, you
should buy all the cases.
8. Reexamine the capital investment decision in the disposable diaper industry (Example
15.3) from the point of view of an incumbent firm. If P&G or KimberlyClark were to
expand capacity by building three new plants, they would not need to spend $60 million on
R&D before startup. How does this advantage affect the NPV calculations in Table 15.5?
Is the investment profitable at a discount rate of 12 percent?
If the only change in the cash flow for an incumbent firm is the absence of a $60
million expenditure in the present value, then the NPV calculations in Table 15.5
simply increase by $60 million for each discount rate:
Discount Rate: 0.05 0.10 0.15
NPV: 140.50 43.50 15.10
To determine whether the investment is profitable at a discount rate of 12 percent, we
must recalculate the expression for NPV. At 12 percent,
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$16.3 million.
Thus, the incumbent would find it profitable to expand capacity.
9. Suppose you can buy a new Toyota Corolla for $15,000 and sell it for $6,000 after six
years. Alternatively, you can lease the car for $300 per month for three years and return it
at the end of the three years. For simplification, assume that lease payments are made
yearly instead of monthly, i.e., are $3,600 per year for each of three years.
a. If the interest rate, r, is 4 percent, is it better to lease or buy the car?
To answer this question, you need to compute the NPV of each option. The NPV of
buying the car is:
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The NPV of leasing the car is:
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In this case, you are better off buying the car because the NPV is higher.
b. Which is better if the interest rate is 12%?
To answer this question, you need to compute the NPV of each option. The NPV of
buying the car is:
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The NPV of leasing the car is:
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In this case, you are better off leasing the car because the NPV is higher.
c. At what interest rate would you be indifferent between buying and leasing the car?
You are indifferent between buying and leasing if the two NPV’s are equal or:
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In this case, you need to solve for r. The easiest way to do this is to use a spreadsheet
and calculate the two NPV’s for different values of r as is done in the table below. The
table shows that at an interest rate of 4.35%, the two NPV’s are almost identical.
r NPV Buy NPV Lease
0.04 -10258.113 -10389.941

0.042 -10312.461 -10370.532
0.043 -10339.362 -10360.865
0.0435 -10352.745 -10356.04
0.044 -10366.083 -10351.222
0.045 -10392.626 -10341.604
0.05 -10522.708 -10293.878
0.06 -10770.237 -10200.214
0.07 -11001.947 -10108.865
0.08 -11218.982 -10019.753
0.09 -11422.396 -9932.8003
0.1 -11613.156 -9847.9339
0.12 -11960.213 -9684.1837
10. A consumer faces the following decision: she can buy a computer for $1,000 and pay
$10 per month for Internet access for three years, or she can receive a $400 rebate on the
computer (so that it costs $600) but agree to pay $25 per month for three years for Internet
access. For simplification, assume that the consumer pays the access fees yearly (i.e.,$10
per month = $120 per year).
a. What should the consumer do if the interest rate is 3 percent?
To figure out the best option, you need to calculate the NPV in each case. The NPV of
the first option is:
271
272
The NPV of the second option with the rebate is:
273
274
In this case, the first option gives a higher NPV so the consumer should pay the $1000
now and pay $10 per month for Internet access.
b. What if the interest rate is 17 percent?
To figure out the best option, you need to calculate the NPV in each case. The NPV of
the first option is:
275
276
The NPV of the second option with the rebate is:
277
278
In this case, the first option gives a higher NPV so the consumer should pay the $1000
now and pay $10 per month for Internet access.
c. At what interest rate is the consumer indifferent between the two options?
The consumer is indifferent between the two options if the NPV of each option is the
same. To find this interest rate set the NPV’s equal and solve for r.
120 120 300 300
1,000  120    600  300  
1  r (1 r) 2
1  r (1 r )2
180 180
220  
1 r (1  r) 2
220(1  r )2  180(1  r)  180
220r2  260r  140  0.
Using the quadratic formula to solve for the interest rate r results in r=40.2%
(approximately).
279

Chapter 15 Investment, Time, and Capital Markets: Teaching Notes

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Chapter 15 Investment, Time, and Capital Markets: Teaching Notes

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Chapter 15: Investment, Time and Capital Markets

Algebraically, FV = PDV(1 + R)t, where PDV is the present discounted value of the

50t 0.5  10t 0.5  0 , or t = 5.

Discount Rate: 0.05 0.10 0.15

NPV: 140.50 43.50 15.10

r NPV Buy NPV Lease

0.04 -10258.113 -10389.941

You might also like

Chapter 15 Investment, Time, and Capital Markets: Teaching Notes

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Chapter 15 Investment, Time, and Capital Markets: Teaching Notes

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Chapter 15 Investment, Time, and Capital Markets: Teaching Notes

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Chapter 15: Investment, Time and Capital Markets

Algebraically, FV = PDV(1 + R)t, where PDV is the present discounted value of the

50t 0.5  10t 0.5  0 , or t = 5.

Discount Rate: 0.05 0.10 0.15

NPV: 140.50 43.50 ­15.10

r NPV Buy NPV Lease

0.04 -10258.113 -10389.941

You might also like

NPV: 140.50 43.50 15.10