7. The net present value theory of how investments should be chosen offers decision makers a tool by which they can evaluate several different alternatives when the investment period extends over some period of time. The idea is based on the idea that investments (loans) are undertaken with the expectation that future benefit will be received, but that the future benefit in question must be paid for with the loan. Generally, the goal is for investments to be self-sustaining; that is, the loan should generate benefits sufficient to cover the repayment of the loan. If additional funds must be generated to cover the repayment, the investment is considered a poor one (Milgrom and Roberts 452).
Just as a borrower takes out a loan to generate some sort of benefit (in the case of a business, the benefit is typically a stream of revenue), so the lender considers the loan an investment. In exchange for making funds available to the borrower, the lender charges an interest rate; that interest rate is the lender's own cash flow. Banks charge interest rates to their borrowers, and pay interest rates to their depositors (from whom the banks are essentially "borrowing" funds). Similarly, interest (coupons) are paid on corporate bonds. When considering investments of this type, decision makers typically take into account the interest rate that they will be earning on their funds. Over time, this rate of return provides a gauge by which investments can be measured.
The net present value theory takes into account the interest rate and projected cash flows for the life of the loan, and then calculates whether the loan can be repaid from those cash flows (Milgrom and Roberts 451). The interest rate is used to generate an accumulation factor; the accumulation factor is equal to 1 plus the interest rate (i) raised to the power of the time period (t). For example, if payments are to be made over five years, the first year's accumulation fact...