# CHAPTER 15 - PHALL-82241 PINDYCK CHAPTER 15 page 6 of 10...

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Unformatted text preview: PHALL-82241 PINDYCK CHAPTER 15 page 6 of 10 FIGURE 15.1 Present Value of the Cash Flow from a Bond PDV of 2.0 cash flow 1.9 (thousands of dollars) 1.8 1.7 1.6 1.5 1.4 1.3 1.2 1.1 1.0 0.9 0.8 0.7 0.6 0.5 0 0.05 0.10 0.15 0.20 Interest rate Because most of the bond’s payments occur in the future, the present discounted value declines as the interest rate increases. For example, if the interest rate is 5 percent, the PDV of a 10-year bond paying \$100 per year on a principal of \$1000 is \$1386. At an interest rate of 15 percent, the PDV is \$749. Fig 15-01.eps PHALL-82241 PINDYCK CHAPTER 15 page 7 of 10 FIGURE 15.2 Effective Yield on a Bond PDV of payments (value of bond) (thousands of dollars) 2.0 1.9 1.8 1.7 1.6 1.5 1.4 1.3 1.2 1.1 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0 0.05 0.10 0.15 0.20 Interest rate The effective yield is the interest rate that equates the present value of the bond’s payment stream with the bond’s market price. The figure shows the present value of the payment stream as a function of the interest rate. The effective yield is found by drawing a horizontal line at the level of the bond’s price. For example, if the price of this bond were \$1000, its effective yield would be 10 percent. If the price were \$1300, the effective yield would be about 6 percent; if the price were \$700, it would be 16.2 percent. Fig 15-02.eps PHALL-82241 PINDYCK CHAPTER 15 page 8 of 10 FIGURE 15.3 Net Present Value of a Factory Net present value (millions of dollars) 10 9 8 7 6 5 4 3 2 1 0 –1 –2 –3 –4 –5 –6 0 0.05 R* 0.10 0.15 0.20 Discount rate, R The NPV of a factory is the present discounted value of all the cash flows involved in building and operating it. Here it is the PDV of the flow of future profits less the current cost of construction. The NPV declines as the discount rate increases. At discount rate R*, the NPV is zero. Fig 15-03.eps PHALL-82241 PINDYCK CHAPTER 15 page 9 of 10 FIGURE 15.4 Price of an Exhaustible Resource Price Price PT PT Demand P0 P0 P–c c c Marginal Extraction Cost T (a) Q0 Time Quantity (b) In (a), the price is shown rising over time. Units of a resource in the ground must earn a return commensurate with that on other assets. Therefore, in a competitive market, price less marginal production cost will rise at the rate of interest. Part (b) shows the movement up the demand curve as price rises. Fig 15-04.eps PHALL-82241 PINDYCK CHAPTER 15 page 10 of 10 FIGURE 15.5 Supply and Demand for Loanable Funds R Interest rate S R* DF DT DH Q* Quantity of loanable funds Market interest rates are determined by the demand and supply of loanable funds. Households supply funds in order to consume more in the future; the higher the interest rate, the more they supply. Households and firms both demand funds, but the higher the interest rate, the less they demand. Shifts in demand or supply cause changes in interest rates. Fig 15-05.eps ...
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## This note was uploaded on 09/28/2011 for the course ECON 105 taught by Professor Prof.eco during the Spring '11 term at Indian School of Business.

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