Summary

1. Using compound interest rates, present discounted value (PDV) allows consumers to compare the costs and benefits of an investment over time in a consistent way by putting the future benefits of a given investment into its present-day dollar value. [Section 14.1]

2. Net present value (NPV) analysis incorporates the PDVs of both the costs and benefits of an investment to arrive at a summary measure of the investment’s return. The concept of a payback period, the length of time before an investment’s initial costs are recouped in future benefits, provides another way of determining the net benefits of a given investment. The weakness of payback periods is that, unlike NPV analysis, they do not discount future cash flows. [Section 14.2]

3. The real interest rate captures the difference between an investment’s nominal interest rate expressed in currency values and the inflation rate. The equilibrium interest rate, as with any good’s price, equates the quantities supplied and demanded of a good, which in this case is capital. [Section 14.3]

4. Investing can be a risky and uncertain undertaking. Evaluating investments using expected value—or the expected outcome of an investment—is one way to include risk in NPV analysis. For risky investments, there is often an option value of waiting, that is, waiting to invest may eliminate some or all of the uncertainty. [Section 14.4]

5. A risk-averse person gains more utility from a set amount of income than from the equivalent amount in expected value from an uncertain income. Because it reduces the policyholder’s risk, insurance increases the individual’s expected utility. Through practices such as diversification and by designing policies to capture some of the policy’s value to the consumer, insurers also benefit from selling insurance policies. [Section 14.5]