Financial Markets & Decisions 1–

BEE2027

Lecture 2

Intertemporal Choice

Lecturer: Dr Obaid Awan

Term 2 – Week 2
The Time Value of Money

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The Time Value of Money

Implicit assumptions/requirements for NPV calculations

 Cashflows are known (magnitudes, signs, timing)
 Exchange rates are known
 No frictions in currency conversions

Do these assumptions hold in practice?

 Which assumptions are most often violated?
 Which assumptions are most plausible?

For now, we will take these assumptions as truth

 Focus now on exchange rates
 Where do they come from, how are they determined?

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Question

Why is £1 worth more today ( than in 1 year (?

Inflation

Impatience

Opportunity Cost

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The Time Value of Money: Future Value

What determines the growth of £1 over years?

 £1 today should be worth more than £1 in the future (why?)
 Supply and demand
 Opportunity cost of capital

 Equivalence of £1 today and any other single choice above

 Other choices are future values of £1 today

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The Time Value of Money: Present Value

What determines the value today of £1 in year ?

 £1 in Year- should be worth less than £1 today (why?)
 Supply and demand
 Opportunity cost of capital

 Calculate the present-value of £1 in the future

 These are our “exchange rates” (, or discount factors

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The Time Value of Money

 We now have an explicit expression for NPV at time 0

Using this expression, any cashflow can be valued!

Take positive-NPV projects, reject negative NPV-projects
 Projects ranked by magnitudes of NPV
 All decisions in capital budgeting and corporate finance reduce to
this expression
 However, we still require many assumptions (perfect markets)

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The Time Value of Money: Example 1

Example I

 Suppose you have $1 today and the interest rate is 5%. How much
will you have in …
Year 1
Year 2
Year 3

 $1 today is equivalent to in years (Future Value)

 $1 in years is equivalent to today (Present Value)

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The Time Value of Money: Example 1

Present value of $1 received in Year

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The Time Value of Money: Example 2

Example 2: Lighting system

 Your firm spends $800,000 annually for electricity at its Boston

headquarters. Johnson Controls offers to install a new computer-
controlled lighting system that will reduce electric bills by
$90,000 in each of the next three years. If the system costs
$230,000 fully installed, is this a good investment?
 Assume the cost savings are known with certainty and the interest
rate is 4%

Lighting system
Year 0 1 2 3
Cashflow -230k 90k 90k 90k

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The Time Value of Money: Example 2

Example 2: Lighting system

Lighting system
Year 0 1 2 3
Cashflow -230k 90k 90k 90k

Present value -230k 86,538 83,210 80,010

Project looks good!

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The Time Value of Money: Example 3

Example 3: Takeover
 CNOOC recently made an offer of $67 per share for Unocal. As part

of the takeover, CNOOC will receive $7 billion in low-cost loans

from its parent company: a zero-interest, 2-year loan of $2.5 billion
and a 3.5%, 30-year loan of $4.5 billion.
 If CNOOC normal borrowing rate is 8%, how much is the interest

subsidy worth?
Interest savings, Loan 1
Interest savings, Loan 2
Total interest savings

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Special Cashflows

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Perpetuity

A Perpetuity pays a constant cashflow forever

 How much is an infinite constant cashflow of each year worth?
 An annuity with infinite maturity: UK Consol bond (2.5%

coupon)

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Annuity
An annuity pays a constant cashflow for periods

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Relation between Annuity and Perpetuity: Example

Example
 You just won the lottery, and it pays $100,000 a year for 20 years.

Are you now a millionaire? Suppose that .

 What if the payments last for 50 years?

 How about forever (a perpetuity)?

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Growing Annuity
A growing annuity pays a cashflow with a constant growth rate for
periods

 The non-discounted income stream is

 The PV is then

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Growing Annuity

How do we derive the formula for a growing annuity?

Derivation Posted on ELE

Hint: geometric series

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Growing Perpetuity

A growing perpetuity pays a cashflow with a constant growth

rate forever

 The non-discounted income stream is

 The PV is then

if or the present value will be negative or asymptotically zero.

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The intertemporal choice problem

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Intertemporal choice

 Intertemporal Choice
 Persons often receive income in “lumps”; e.g., monthly salary.
 How is a lump of income spread over the following month (saving now for
consumption later)?
 Or how is consumption financed by borrowing now against income to be
received at the end of the month

 Present and Future Values

 Begin with some simple financial arithmetic.
 Take just two periods; 1 and 2.
 Let denote the interest rate (opportunity cost) per period.

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Future value

 E.g., if then $100 saved at the start of period 1 becomes $110 at the
start of period 2.
 The value next period of $1 saved now is the future value of that
dollar.

 Given an interest rate the future value one period from now of $1 is

 Given an interest rate the future value one period from now of $m
is

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Present value

 The present value of $1 available at the start of the next period is

 And the present value of available at the start of the next period is

 E.g., if then the most you should pay now for $1 available next
period is

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The intertemporal choice problem
 Before: the consumer choice problem
(budget constraint)

 Now: the intertemporal choice problem

 Let m1 and m2 be incomes received in periods 1 and 2.
 Let c1 and c2 be consumptions in periods 1 and 2.
 Let p1 and p2 be the nominal prices of consumption in periods 1 and 2.
Endowment
𝑚1 𝑚2
𝑡
1 2
Present value Future value

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The intertemporal choice problem

The intertemporal choice problem

 Given incomes and , and given nominal consumption prices and ,
what is the most preferred intertemporal consumption bundle
(, )?

 For an answer we need to know:

1. The intertemporal budget constraint
2. The intertemporal consumption preferences

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The intertemporal budget constraint

Scenario 1: Suppose that…

 the consumer chooses not to save or to borrow.
 For now, we ignore price effects (i.e., nominal prices

 What will be consumed in period 1?

 What will be consumed in period 2?

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The intertemporal budget constraint
Period 2
consumption

c2 So is the
consumption bundle if the
consumer chooses neither to
save nor to borrow.

Endowment Point

m2

Period 1
consumption
0
0 m1 c1

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The intertemporal budget constraint
Scenario 2: Now suppose that …
 The consumer spends nothing on consumption in period 1, i.e.
 The consumer saves
 The interest rate is

 What will now be the period 2 consumption level?

1. Period 2 income is .
2. Savings with interest from period 1 are
3. Hence, total income available in period 2 is
 Period 2 consumption expenditure is

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The intertemporal budget constraint
The consumer spends nothing on
consumption in period 1, i.e.

c2 the future-value of the income

endowment
𝑚2 + ( 1+𝑟 ) 𝑚1

is the consumption bundle when all

period 1 income is saved.

m2

0
0 m1 c1

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The intertemporal budget constraint

Scenario 3: Now suppose that …

 The consumer spends everything possible on consumption in period 1,
i.e., .
 What is the most that the consumer can borrow in period 1
against her period 2 income of ?
 Let denote the amount borrowed in period 1.

 Only will be available in period 2 to pay back borrowed in period

1.
 So,
 That is,
 So, the largest possible period 1 consumption level is

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The intertemporal budget constraint

is the consumption bundle when all

c2 period 1 income is saved.

𝑚2 + ( 1+𝑟 ) 𝑚1

is the consumption bundle when

period 1 borrowing is as big as
possible.

m2 the present-value of
the income endowment

0
0 m1 c1
𝑚2
𝑚1 +
1+𝑟

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The intertemporal budget constraint

Scenario 4: Now suppose that …

 units are consumed in period 1.
 This costs and leaves saved.

 Period 2 consumption will then be

Present-value expression of
or similarly, the intertemporal budget
constraint

which is Slope Intercept

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The intertemporal budget constraint

c2
is the consumption bundle when period
𝑚2 + ( 1+𝑟 ) 𝑚1 1 saving is as large as possible

is the consumption bundle when

borrowing from period 2 is as large
m2 as possible

0
0 m1 c1
𝑚2
𝑚1 +
1+𝑟

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The intertemporal budget constraint

c2

𝑚2 + ( 1+𝑟 ) 𝑚1

m2

0
0 m1 c1
𝑚2
𝑚1 +
1+𝑟

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The intertemporal budget constraint

c2

𝑚2 + ( 1+𝑟 ) 𝑚1

Sa
v in g

m2
Bo
r ro
wi
ng

0
0 m1 c1
𝑚2
𝑚1 +
1+𝑟

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The intertemporal budget constraint

 Present-valued budget constraint:

 The form of the budget constraint since all terms are in period 1 values

 Future-valued budget constraint:

 The form of the budget constraint where all terms are in period 2 values

 The two forms are equivalent!

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Example: Varian Workouts 10.2

We saw earlier that if utility has the form and the budget constraint is
of the “standard” form , then the demand functions for the goods are
and .

Molly has a Cobb-Douglas utility function (,, where and where

and are her consumptions in periods 1 and 2 respectively.

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Example: Varian Workouts 10.2

a) What is the budget constraint in present value?

b) In terms of Molly’s budget constraint, what is and ?
c) If , what are the demand functions for and ?
d) Will an increase in the interest rate (increase/decrease) her period-1
consumption?
e) Will it (increase/decrease) her period-2 consumption and
(increase/decrease) her savings in period 1?

Video on ELE

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Price Effects

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Add Prices

Scenario 5: Add prices

 Now let’s add prices and for consumption in periods 1 and 2 and define
endowment as being measured in units of consumption:

 How does this affect the budget constraint?

 Given the endowment and prices what intertemporal

consumption bundle will be chosen by the consumer?

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The intertemporal budget constraint

 Take the opportunity cost of capital into consideration, hence the

general form

 Becomes
 Present valued:
 Future valued:

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The intertemporal budget constraint

Note that
 Without price effects, , the budget constraints simplify to:
 Present valued:

 Future valued:

 The same as before!

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The intertemporal budget constraint

With prices, maximum possible expenditure is:

 Period 2
 Maximum possible expenditure in period 2 is
 So, the maximum possible consumption in period 2 given price is

 Period 1
 Similarly, maximum possible expenditure in period 1 is
 So, the maximum possible consumption in period 1 given price is

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The intertemporal budget constraint

c2

𝑝1
𝑚2 +𝑚1 ( 1+𝑟 )
𝑝2

Sa
v in g

𝒎𝟐
𝒑𝟐 Bo
r ro
wi
ng

0 𝒎𝟏 c1
1 𝑝2
𝒑 𝟏 𝑚1 +𝑚2
1+ 𝑟 𝑝 1

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Price inflation

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Price inflation

 Define the inflation rate by where:

 means 2% inflation, and

 means 100% inflation.

 A price effect such as inflation means that

 Set so that

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Price inflation

 The budget constraints of in terms of consumption then become

 Present valued:

 Future valued:

Or

 Which we can rearrange to the useful form

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Comparative statics

 The slope of the budget constraint with price inflation is

 The constraint becomes flatter if the interest rate falls or the

inflation rate rises (both decrease the real rate of interest).

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Comparative statics
1 +𝑟
slope =−
1+ 𝜋
c2 The consumer saves.

𝒎𝟐
𝒑𝟐

0
0 𝒎𝟏 c1
𝒑𝟏

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Comparative statics
1 +𝑟
slope =−
1+ 𝜋
c2 The consumer saves.

An increase in the inflation rate

or a decrease in the interest rate
“flattens” the budget constraint.

If the consumer saves, then

savings and welfare are
𝒎𝟐 reduced by a lower interest
𝒑𝟐 rate or a higher inflation rate.

0
0 𝒎𝟏 c1
Bundles to the right of endowment 𝒑𝟏
point were unattainable before 
might become a borrower 52
Comparative statics

Before
 The consumer saves and interest rates decrease

What if?
 The consumer borrows and interest rates decrease
 The consumer borrows and interest rates increase
 The consumer saves and interest rates increase

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Outlook

Tutorial
 Questions from the Varian Chapter 10 Workouts posted on ELE
 Attempt the questions before the tutorial!

Lecture next week

 Varian Chapter 11: Asset Markets

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