L1 | Present Values

Question 1

What is the net present value (NPV)?

Answer 1

the present value of sum of all future cash flows minus the required investment

Question 2

How long is a perpetuity for?

Answer 2

forever

Question 3

How long is an annuity for?

Answer 3

a specified number of years

Question 4

How do we calculate the IRR?

Answer 4

the IR value when NPV = 0

Question 5

What is the present value formula for a perpetuity?

Answer 5

Question 6

What is the present value formula for a perpetuity when the first payment is made in year t+1?

Answer 6

Question 7

What is the present value formula for an annuity?

Answer 7

Question 8

What is the present value formula for a perpetuity with growth?

Answer 8

Question 9

What is the present value formula for an annuity with growth?

Answer 9

Question 10

What is meant by the budget constraint?

Answer 10

Level of consumption in second period is a function of the amount of income spent in first period

Question 11

What is the budget constraint?

the inequality formula

Answer 11

c1 = consumption in second period; M1 = income at start of second period; M0 = income at start of second period; C0 = consumption level in first period

Question 12

Level of consumption in the second period is a function of…

Answer 12

amount of income spent in first period

Question 13

When does an individual lend?

Answer 13

if C0 < M0 and C1 > M1

Question 14

When does an individual borrow?

Answer 14

if C0 > M0 and C1 < M1

Question 15

Optimal Consumptionb

If IR increases, what happens to the CML and what is the result to the individual?

Answer 15

• slope increases
• CML pivots around the endowment point
• beneficial to consume less today because what is left will be inflated more by r
• so consume more next period

Question 16

How are consumer preferences for current and future consumption represented?

Answer 16

utility function (C0,C1) and associated set of indifference curves

Question 17

What does the slope of the indifference curves represent?

Answer 17

Marginal Rate of Substitution (MRS) = rate at which consumers will trade of consumption today for consumption tomorrow

Question 18

Where does an individual’s consumption package lie on the graph?

Answer 18

where the slope of the highest indifference curve is tangential to the CML

Question 19

Optimal Investment

What is meant by the production possibility frontier?

Answer 19

a curve showing maximum output possibilities of consumption good in 2 periods

Question 20

What is meant by the slope of the Production Possibility Frontier?

Answer 20

Marginal Rate of Transformation (MRT) = rate at which it is technically feasible for one unit of C0 to be transformed into units of C1

Question 21

What is the solution to optimal investment?

Answer 21

where CML is tangential to PPF

Where MRT = (1+r)

Question 22

How do we combine optimal investment and optimal consumption?

Answer 22

• Optimal consumption requires MRS = 1+r
• Optimal investment requries MRT = 1+r
• Optimal investment and consumption when MRS=MRT

Question 23

In the absense of capital markets, the condition for optimal consumption/investement is given by…

Answer 23

MRS = MRT

Question 24

In the absence of capital markets, if MRT < (1+r) and MRS < (1+r), how can utility be increased?

Answer 24

if capital markets introduced by lending and increasing next period’s consumption

Question 25

In the absence of capital markets, if MRT > (1+r) and MRS > (1+r), how can utility be increased?

Answer 25

if capital markets introduced by borrwing and increasing the present period’s consumption

Question 26

What is the Fisher Separation Theorem?

Answer 26

a firm’s choice of investment is separate from its owners’ investment preferences and therefore the firm should only be motivated to maximize profits.

Question 27

What is the power of the Fisher separation result?

Answer 27

even if entrepreneur and consumer are different:
all shareholders and managers agree on the optimal investment policy
unanimity with respect to the firm’s objectives.