0:12

Now, let's add another layer of complexity to

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

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

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

Well, on the supply side,

let's suppose the federal government significantly expands

the Social Security retirement program to more

fully cover the cost of hospitalization and retirement.

What is this likely to do to the supply curve for

loanable funds and the market rate of interest?

Let's pause the presentation now to think just

a bit about this.

1:02

Well, the most likely response to

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

That is, people will be less thrifty.

Of course, this will shift the supply curve for

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

Now, what about the demand side?

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

but begins moving towards full employment as it recovers.

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

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

1:48

Well, as the economy improves more businesses are likely

to increase their investment in new plant and equipment.

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

increase the interest rate.

Now, in the example above

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

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

That is, we invested in something at the beginning of

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

Of course, that's a pretty artificial example because

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

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

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

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

A question now is this,

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

but the benefits from that investment come in the form of

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

In order to answer this question,

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

Before I explain this concept,

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

including present discounted value or just plain present value.

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

it provides us with the time value of money.

As for its key definition,

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

Let me repeat that, net present value is defined as

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

4:09

Okay, let's give net present value

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

Suppose then you own an apartment building that

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

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

the night to complain about

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

Enough already, you say.

So you decide to sell the building.

But how much should you sell it for?

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

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

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

Well, to move us

towards an answer to this question,

let's start with a very simple example,

and one again for only a one year investment.

Let's suppose then that somebody offers to sell you

a bottle of wine that matures in exactly one year.

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

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

What is the net present value of the wine?

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

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

5:50

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

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

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

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

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

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

A perpetuity is an asset

like land that lasts forever and pays

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

The question, of course is this,

how would you evaluate a perpetuity?

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

It is simply this, V=N/I,

where V equals the present value of the land,

N is the permanent annual receipts from the land,

and I is the interest rate in decimal terms.

So let's give this formula a spin now.

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

What would be the net present value of the perpetuity?

Let's pause now to figure this out.

7:23

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

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

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

but first we have to make some assumptions.

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

Then let's further assume that after expenses,

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

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

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

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

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

8:24

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

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

By the way, what would be the selling price if

the interest rate was 10 percent instead of 5 percent?

8:50

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

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

Now, let's move on,

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

one of the most important tools in the MBA toolbox.