KWCh_07_The_Concept_of_Present_Value -...

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Unformatted text preview: >> Making Decisions Section 4: The Concept of Present Value chapter 7 In many cases, individuals must make decisions whose consequences extend some ways into the future. For example, when you decide to attend college, you are com- mitting yourself to years of study, which you expect will pay off for the rest of your life. So the decision to attend college is the decision to embark on a long-term project. As we have already seen, the basic rule in deciding whether or not to undertake a project is that you should compare the benefits of that project with its costs, implic- it as well as explicit. But sometimes there can be a problem in making these compar- isons: the benefits and costs of a project may not arrive at the same time. Sometimes the costs of a project come at an earlier date than the benefits. For example, going to college involves large immediate costs: tuition, income forgone because you are in school, and so on. The benefits, such as a higher salary in your future career, come later, often much later. In other cases, the benefits of a project come at an earlier date than the costs. If you take out a loan to pay for a vacation cruise, the satisfaction of the vacation will come immediately, but the burden of making payments will come later. But why is time an issue? Borrowing, Lending, and Interest In general, having a dollar today is worth more than having a dollar a year from now. To see why, lets consider two examples. First, suppose that you get a new job that comes with a $1,000 bonus, which will be paid at the end of the first year. But you would like to spend the extra money now say, on new clothes for work. Can you do that? The answer is yesyou can borrow money today and use the bonus to repay the debt a year from now. But if that is your plan, you cannot borrow the full $1,000 today. You must borrow less than that, because a year from now you will have to repay the amount borrowed plus interest . Now consider a different scenario. Suppose that you are paid a bonus of $1,000 today, and you decide that you dont want to spend the money right now. What do you do with it? You put it in the bank; in effect, you are lending the $1,000 to the bank, which in turn lends it out to its customers who wish to borrow. At the end of a year, you will get more than $1,000 backyou will have the $1,000 plus the inter- est earned. What all of this means is that $1,000 today is worth more than $1,000 a year from now. The reason is that if you want to have the money today, you must borrow it and pay interest. That is, you must pay a price for using the money today. And, corre- spondingly, if you forgo using the money today and lend it to someone else, you earn interest on the money. That is, you earn something by letting someone else use your money. When someone borrows money for a year, the interest rate is the price, cal- culated as a percentage of the amount borrowed, charged by the lender....
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This note was uploaded on 04/13/2010 for the course ECON 1110 taught by Professor Wissink during the Fall '06 term at Cornell University (Engineering School).

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KWCh_07_The_Concept_of_Present_Value -...

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