0:12

Now, let's add another layer of complexity to

Â our understanding of the market for loanable funds by asking this question.

Â How might events in the real world cause the demand or supply curve to

Â shift and thereby change the interest rate and the economy's level of investment?

Â Well, on the supply side,

Â let's suppose the federal government significantly expands

Â the Social Security retirement program to more

Â fully cover the cost of hospitalization and retirement.

Â What is this likely to do to the supply curve for

Â loanable funds and the market rate of interest?

Â Let's pause the presentation now to think just

Â a bit about this.

Â 1:02

Well, the most likely response to

Â this new government policy is that people will save less for their retirement.

Â That is, people will be less thrifty.

Â Of course, this will shift the supply curve for

Â loanable funds inward and the market rate of interest will rise.

Â Now, what about the demand side?

Â Well, suppose the economy has been in a deep recession,

Â but begins moving towards full employment as it recovers.

Â What do you think will happen to the interest rate and why?

Â Again, let's pause and think about this for a minute.

Â 1:48

Well, as the economy improves more businesses are likely

Â to increase their investment in new plant and equipment.

Â This will, of course, shift out the demand curve for loanable funds and thereby

Â increase the interest rate.

Â Now, in the example above

Â we made it really easy to evaluate the firms investment decision.

Â In particular, we made it easy by limiting the investment horizon to only one year.

Â That is, we invested in something at the beginning of

Â the year and got our return at the end of the year.

Â Of course, that's a pretty artificial example because

Â most investments last more than one year after our initial outlay of funds.

Â In fact, these investment horizons can range from a few years for

Â a new computer or some office furniture up to 30 to 40 years for an electric power plant,

Â and more than 50 or 100 years for a big skyscraper.

Â A question now is this,

Â how do you evaluate an investment when your capital outlay occurs today,

Â but the benefits from that investment come in the form of

Â a revenue stream over the course of many years and tomorrows?

Â In order to answer this question,

Â we have to introduce one of the most important concepts in economics, net present value.

Â Before I explain this concept,

Â let me point out that net present value goes by various other names as well

Â including present discounted value or just plain present value.

Â But regardless of which name is used the key concept behind net present value is this,

Â it provides us with the time value of money.

Â As for its key definition,

Â net present value is defined as the dollar value today of a stream of income over time.

Â Let me repeat that, net present value is defined as

Â the dollar value today of a stream of income over time.

Â 4:09

Okay, let's give net present value

Â some real world context so we can really wrap our minds around it.

Â Suppose then you own an apartment building that

Â generates rental payments $10,000 per month from your tenants.

Â Let's suppose further that your tenants are always calling you up in the middle of

Â the night to complain about

Â a leaky faucet or a blocked toilet or a broken waste disposal.

Â Enough already, you say.

Â So you decide to sell the building.

Â But how much should you sell it for?

Â More specifically, what lump sum payment money today would make you at least as

Â well off as that stream of rental payments you would get over the life of the building?

Â Let's pause the presentation now to think about this for a minute.

Â Well, to move us

Â towards an answer to this question,

Â let's start with a very simple example,

Â and one again for only a one year investment.

Â Let's suppose then that somebody offers to sell you

Â a bottle of wine that matures in exactly one year.

Â Now, further suppose that the wine can be sold for $11 at the end of the year,

Â assuming that the market interest rate is 10 percent per year.

Â What is the net present value of the wine?

Â That is, how much would you pay for the wine today?

Â Let's pause now as you calculate a possible answer.

Â 5:50

Well, the most you would pay is $10 dollars.

Â Why? Because $10 invested today at the 10 percent market rate of interest,

Â would yield you $11 at the end of the year.

Â So in other words, the present value of next year's $11 wine is $10.

Â That's an example for only a one year investment.

Â Now, let's go to the other extreme examining what's called a perpetuity.

Â A perpetuity is an asset

Â like land that lasts forever and pays

Â a certain amount of dollars per year from now to eternity.

Â The question, of course is this,

Â how would you evaluate a perpetuity?

Â Well, there is actually a very simple formula to do this.

Â It is simply this, V=N/I,

Â where V equals the present value of the land,

Â N is the permanent annual receipts from the land,

Â and I is the interest rate in decimal terms.

Â So let's give this formula a spin now.

Â The interest rate is 5 percent per year and the perpetuity yields $100 a year.

Â What would be the net present value of the perpetuity?

Â Let's pause now to figure this out.

Â 7:23

Well, the answer is $2,000 or simply $100 divided by 0.05.

Â In fact, we can use this formula for a perpetuity to determine

Â what the selling price of our hypothetical apartment building should be,

Â but first we have to make some assumptions.

Â Let's first assume that the prevailing interest rate is 5 percent.

Â Then let's further assume that after expenses,

Â our gross monthly rental income of $10,0000 is reduced to

Â a net income of just $5,000 that's $60,000 per year.

Â So based on that net rental income and assuming that the building will last forever,

Â what is the least amount of money that we should sell the building for?

Â Again, let's pause the presentation, figure this out.

Â 8:24

Well, the selling price should be at least 1.2 million dollars.

Â This is found simply by dividing $60,000 by the interest rate.

Â By the way, what would be the selling price if

Â the interest rate was 10 percent instead of 5 percent?

Â 8:50

That's right, it would be only $600,000.

Â So you see here how sensitive the calculation is to the assumed interest rate.

Â Now, let's move on,

Â when you're ready to the next module where I will unveil the net present value equation,

Â one of the most important tools in the MBA toolbox.

Â