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Classes of External Decisions

Classes of External Decisions. Investment Decisions Distribution Decisions. Investment decision = sacrificing current wealth for increased wealth in the future. Wealth = command over good and services. Features of Investment Decisions.

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Classes of External Decisions

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  1. Classes of External Decisions Investment Decisions Distribution Decisions

  2. Investment decision = sacrificing current wealth for increased wealth in the future. Wealth = command over good and services.

  3. Features of Investment Decisions 1. Investment alternatives associated with a stream of expected economic consequences example: 2. Expected consequences are uncertain example: 3. Expected consequences differ in timing and magnitude example:

  4. Assumptions Underlying Our Decision Model 1. Expected consequences can be expressed in terms of money flows 2. Expected cash flows are certain 3. No decision constraints

  5. (.25-.10) 24,000 (.25 - .11) 24,000 (.25-.12)24,000 -4,500 =3,600 =3,360 =3,120 Chevy |___________|___________|_____________| 1 2 3 (.25 - .08)24,000 (.25-.07) 24,000 (.25-.06) 24,000 -6,900 =4,080 =4,320 =4,560 Fiat |___________|___________|_____________| 1 2 3

  6. Savings Savings- Costs = Net SavingsPer Year Chevy 10,080 - 4,500 = 5,580 1,860 Fiat 12,960 - 6,900 = 6,060 2,020 Decision: Choose _______________

  7. Time preference rate = f (opportunity rate of return) = the rate of return you require for giving up the use of money for a period of time.

  8. Opportunity Set Passbook savings Money market accounts Tax exempts Junk bonds Stocks

  9. Assume r = 10% $1 + $1(.10) 1(1 + .10) -$1 = 1.10 1

  10. 1(1 + .10) + [1(1 + .10)].10 = 1(1 + .10)(1 + .10) -$1 1(1 + .10) = 1(1 + .10)² = 1.21 2 1

  11. -$1 1(1 + .10) 1(1 + .10)² 1(1 + .10)³ = 1.33 1 2 3

  12. Future Value of a Sum Let FV = future value of a sum r = time preference rate n = number of compounding periods pv = principle sum to be invested at present FV = PV (1 + r)n { interest factor

  13. Problem: What will $1,000 invested at 8% accumulate to at the end of five years? ? $1,000 1 2 3 4 5

  14. FV = PV (1 + r)n = $1,000 (1.47) = $1,470 = $1,000 (1 + .08)5

  15. Future Value of $1 r´s n´s 1% 2% 3% . . . 8% • 1 • 2 • 3 • 4 • 5 • . • . • . 1.47

  16. FV = PV (fvf - .08 - 5) = $1,000 (1.47 = $1,470 )

  17. r = ? { $1 $1.21 |___________________|_________________| 1 2

  18. Present Value of a Sum FV = PV (1 + r)n PV = FV/(1 + r)n = FV 1/(1 + r)n int. factor {

  19. 1 = 1.21 X 1 1.21X = 1 X = 1/1.21 = $.83

  20. $1 $1.21 |___________________|_________________| 1 2 .83 $1

  21. $1 $1.21 |___________________|_________________| 1 2 ? $1

  22. Problem: What is $1,000 promised at the end of five years worth today if r = 8%? ________________________________ ? ___________________________________ 1 2 3 4 5 PV = 1,000 (pvf - .08 - 5) = 1,000 (.681) = $681 $1,000

  23. Annuity 100 100 100 |___________|____________|____________| 1 2 3 100 200 100 |___________|____________|____________| 1 2 3

  24. 200 200 200 |___________|____________|____________| 1 2 3

  25. Present Value of an Annuity(r = 10%) 200 200 200 |___________|____________|____________| 1 2 3 PV = $200(.909) + $200(.826) + $200(.751) = 182 + 165 + 150 = $497

  26. Alternatively, PV = 200 (2.49) = 498

  27. Net Present Value Model of Investment Choice 1. Felt need: Maximize wealth 2. Problem Identification: a. Objective function: cash flows associated with each alternative b. Decision constraints: none c. Decision rule: choose alternative that maximizes wealth 3. Identify alternatives: predicting (estimating) cash flows associated with each alternative

  28. Net Present Value Model of Investment Choice 4. Evaluate alternatives: a. Calculate PV equivalents of each cash inflow and cash outflow associated with each alternative b. Sum the PV’s of the inflows; sum the PV’s of the outflows c. NPV = sum of PV’s of inflows minus sum of present value of outflows 5. Choose alternative that promises the highest NPV!

  29. Auto Replacement Problem Revisited (r = 10%) -4,500 3,600 3,360 3,120 Chevy |__________|____________|___________| 1 2 3 PV’s = -4,500 + 3,600 ( ) + 3,360 ( ) + 3,120 ( ) = -4,500 + 3,272 + 2,775 + 2,343 PV’s = -4,500 + 8,390 NPV = 3,890

  30. Auto Replacement Problem Revisited (r = 10%) -4,500 3,600 3,360 3,120 Chevy |__________|____________|___________| 1 2 3 PV’s = -4,500 + 3,600 (.909) + 3,360 (.826) + 3,120 (.751) = -4,500 + 3,272 + 2,775 + 2,343 PV’s = -4,500 + 8,390 NPV = 3,890

  31. -6,900 4,080 4,320 4,560 Fiat |__________|____________|___________| 1 2 3 PV’s = -6,900 + 4,080 (.909) + 4,320 (.826) + 4,560 (.751) = -6,900 + 3,709 + 3,568 +3,425 PV’s = -6,900 + 10,702 NPV = 3,802 Decision: Choose ____________

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