Foundations of the Net Present Value Rule

Capital Markets - Current vs Future consumption

example: investment returns 14% at end of year, 7% interest rate

Option A - invest $100 now and receive $114 at end of year

Option B - invest $100 and receive $106.54 ($114 x 1.07) now

B is borrowing against future income

Net Present Value Rule - investe in any project with a positive net present value

Rate of Return Rule - invest as long as the return on the investment exceeds the rate of return an equivilant investment in capital markets.

Introduction to Present Value

Present Value of $1 must be less than $1 tomorrow because a $1 today can be invested, etc. Discount Factor - present value of a delayed payoff may be found by multiplying payoff by a discount factor.

Present Value = Discount Factor x Payoff

Discount Factor = 1 (divided by) Rate of Return

Opportunity Cost - rate of return offered by equivalent investment alternatives in capital market.

Net Present Value - Present Value less Required Investment