Now that we understand what the cost and benefits are of different consumption and investment decisions over time, we can understand how both firms and individual consumers make decisions about how much to invest in different types of opportunities. In this lecture, we will discuss how individuals make major decisions, such as whether to attend college and how much to save for retirement.
The savings of individuals drive the growth of our economy. Image courtesy of B3OK on Flickr.
Keywords: Investment decisions; net present value; discount rate; subsidized retirement savings programs.
Before watching the lecture video, read the course textbook for an introduction to the material covered in this session:
- [R&T] Chapter 13, “Interest Rates and the Markets for Capital and Natural Resources.”
- [Perloff] Chapter 16, “Interest Rates, Investments, and Capital Markets.” (optional)
This concept quiz covers key vocabulary terms and also tests your intuitive understanding of the material covered in this session. Complete this quiz before moving on to the next session to make sure you understand the concepts required to solve the mathematical and graphical problems that are the basis of this course.
If a firm is making an investment decision, what measure should it use to compare two different potential projects and decide which to invest in?
The firm should calculate the net revenue from the project in each future period, and weight it by the interest rate to estimate the value of that revenue in today's dollars. Simply summing revenues or profits over time is not an accurate measure of value, because profits that accrue to the firm with a time delay are not as valuable as immediate profits.
If the opportunity cost of attending college increases for a student (i.e., if s/he has to borrow money, rather than using family funds), does the net present value of a college education increase or decrease?
If the opportunity cost of attending college increases, then the net present value of a college education will certainly decrease. While the ultimate benefits of attending college in terms of discounted higher wages have not changed, the up-front costs in terms of tuition payments have increased.
Assume two lottery winners each win a $100 million jackpot that is payable in 20 payments of $5 million each year for 20 years. Lottery Winner #1 has access to a bank account with a real interest rate of 3% annually, while Lottery Winner #2 has access to a bank account with a real interest rate of 5% annually. Which person has a higher present value of their lottery win?
The present value of the lottery win will be higher for Winner #1, because he faces a lower interest rate. As a result, he discounts future payments by a smaller factor than Winner #2. For Winner #2, future payments are relatively less valuable because he could earn a very high interest rate on payments today. The existing level of wealth is not relevant to determining the present value of a given investment.