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Ch 15 Investment - 15 INVESTMENT Econ 100A Mortimer...

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INVESTMENT 15 Econ 100A Mortimer
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INVESTMENT, TIME, AND CAPITAL MARKETS Capital is durable and typically lasts for years, so time is an important element in the purchase of capital goods. Consider and compare: 1) The expenditures the firm would have to incur now 2) The additional profit that the new capital will generate in the future . Econ 100A Mortimer
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STOCKS VERSUS FLOWS Capital is measured as a stock and profits are flows . If a firm plans to build an ice cream factory worth $18 million, we say that it will have a capital stock worth $18 million. Suppose the firm will sell 87,500 pounds of ice cream per month for $3 each. Average variable cost will be $1 per pound. Then, average profit will be $2 per pound and total profit will be $175,000 per month or $2.1 million per year. The firm’s $18 million capital stock will allow it to earn a flow of profit of $2.1 million per year . Is the firm’s $18 million investment in this ice cream factory a good idea? Econ 100A Mortimer
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PRESENT DISCOUNTED VALUE Suppose the annual interest rate is R . Then $D today invested will yield interest rate Rate at which one can borrow or lend money. present discounted value (PDV) The current value of an expected future cash flow. Money received over time is less than money received today because the money can be invested to yield more money in the future. Then the present discounted value (PDV) of $X paid one year from now D(1 + R ) dollars a year from now. Similarly, $1 today invested will yield D(1+R) T dollars T years from now. e.g., R=0.05 (1.05)(10)=$10.50 after 1 year. (1.05)(1.05)(10) = $11.03 after 2 years . is worth $X/(1 + R ) today. $X paid T years from now is worth $X/(1 + R ) T today. e.g., R=0.05 $ 10.50 after 1 year is worth (10.50)/(1.05) =$10 today. $11.03 after 2 years is worth (11.03)/(1.05) 2 =$10 today. Econ 100A Mortimer
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PRESENT DISCOUNTED VALUE Years until Payment is Received 1% 5% 10% 1 $0.99 0.95 0.91 2 0.98 0.91 0.83 3 0.97 0.86 0.75 5 0.95 0.78 0.62 PDV of $1 for Various Time Periods and Interest Rates 10 0.91 0.61 0.39 25 0.78 0.30 0.09 50 0.61 0.09 0.01 100 0.37 0.01 0.00 (0.00007) Econ 100A Mortimer
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PRESENT DISCOUNTED VALUE Valuing Streams of Future Payments Say you are buying a washing machine.
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