ECON 2111 Ch. 15 Investment, Time and Capital Markets Pt. 1 PRESENT DISCOUNTED VALUE

Summary

In this video, the concepts of investment, time, and capital markets are explored, focusing on how businesses evaluate investments using the present discounted value (PDV) of future profits. The script explains key concepts such as the difference between stocks and flows, opportunity cost, and the impact of discount rates on the value of money. It also compares two payment streams, illustrating how varying the discount rate affects which stream is more valuable. By understanding these principles, businesses can make more informed decisions about where to invest and how to assess the potential returns on those investments.

Takeaways

• 😀 The concept of investment is centered around understanding the value of future profits in today's terms.
• 😀 Businesses need to evaluate whether their investment today (e.g., $10 million) will generate a higher value in the future, adjusted for the present time value of money.
• 😀 There is a fundamental distinction between 'stocks' (capital assets) and 'flows' (expenditures) in microeconomics.
• 😀 Stocks represent accumulated capital at a certain point in time, while flows refer to the ongoing expenditures, like wages or revenue, over a period.
• 😀 Opportunity cost is crucial: $1 today has an opportunity cost if it's invested elsewhere or borrowed for a new venture, such as interest lost or paid.
• 😀 The present discounted value (PDV) is the process of adjusting future values to reflect their value in today's money by applying a discount rate.
• 😀 A higher discount rate (interest rate) reduces the present value of future profits because it reflects higher opportunity costs.
• 😀 The PDV of future cash flows depends on the discount rate; a higher rate leads to a smaller PDV, and a lower rate results in a higher PDV.
• 😀 Two different payment streams can be compared: One with a larger upfront payment and another with payments spread out over time. The attractiveness of each depends on the discount rate.
• 😀 In the examples given, when the discount rate is low, upfront payments (stream A) are more valuable, while higher discount rates make future payments (stream B) less valuable.
• 😀 Ultimately, the value of future income streams for a company depends on both the size of initial payments and the discount rate applied to future payments.

Q & A

What is the central idea of Chapter 15 in microeconomics?

The central idea of Chapter 15 is about how businesses make decisions regarding investments in productive ventures, specifically assessing the value of expected profits in future terms, but translated into today's money using present discounted value (PDV).

What are 'stocks' and 'flows' in microeconomics?

'Stocks' refer to the capital assets a business owns at a particular point in time (e.g., machinery, factories). 'Flows' represent the expenditures or revenues that occur over a specific time period (e.g., wages paid, revenue generated).

How does opportunity cost affect investment decisions?

Opportunity cost plays a critical role in investment decisions because businesses must consider what they are forgoing (such as potential interest or alternative investments) when deciding how to allocate capital. This is reflected in the discount rate used to calculate present discounted value (PDV).

What is the formula for calculating present discounted value (PDV)?

The formula for calculating PDV is: PDV = 1 / (1 + r)^n, where 'r' is the discount rate and 'n' is the number of periods (years). This formula discounts future money to reflect its present value.

How does a higher discount rate affect the present value of future money?

A higher discount rate reduces the present value of future money. The higher the discount rate, the more significantly future amounts are discounted, leading to a smaller PDV.

What is the relationship between the discount rate and the PDV?

There is an inverse relationship between the discount rate and PDV: as the discount rate increases, the PDV decreases. Conversely, as the discount rate decreases, the PDV increases, making future money more valuable today.

Why is it important to choose the right discount rate in investment decisions?

The choice of discount rate is crucial because it directly impacts the assessment of an investment's value. A higher discount rate reflects a higher opportunity cost, making future profits appear less valuable, while a lower discount rate makes future profits appear more attractive.

How can businesses compare different payment streams based on PDV?

Businesses can compare different payment streams by calculating the PDV of each stream using an appropriate discount rate. The stream with the higher PDV is considered more valuable. The comparison may depend on factors like the timing of payments and the chosen discount rate.

What is the difference between the two payment stream structures (Stream A and Stream B)?

Stream A involves receiving $100 today and $100 in one year, while Stream B involves receiving $20 today, $100 in one year, and $100 in two years. The PDV of these streams depends on the discount rate, with Stream A becoming more valuable at higher discount rates because it has a larger upfront payment.

How does the timing of payments affect the PDV of payment streams?

The timing of payments affects PDV because earlier payments are less discounted than later payments. For example, receiving $100 today is more valuable than receiving the same amount in the future, as future payments are subject to discounting, which reduces their value in today's terms.