Principles Principles of Corporate Finance
Ninth Edition
Chapter 2
Present Value, The Objectives of The Firm, and Corporate Governance
Slides by Matthew Will
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Topics Covered
Introduction to Present Value Foundations of the Net Present Value Rule Corporate Goals and Corporate Governance
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Present and Future Value
Future Value Amount to which an investment will grow after earning interest Present Value Value today of a future cash flow.
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Discount Factors and Rates
Discount Rate Interest rate used to compute present values of future cash flows.
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Discount Factor Present value of a $1 future payment.
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Future Values
Future Value of $100 = FV
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FV = $100 (1 + r )
t
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Future Values
FV = $100 (1 + r )
Example - FV What is the future value of $100 if interest is compounded annually at a rate of 6% for five years?
t
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FV = $100 (1 + .06) = $133.82
5
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Future Values
FV = $100 (1 + r )
Example - FV What is the future value of $400,000 if interest is compounded annually at a rate of 5% for one year?
t
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FV = $400,000 (1 + .05) = $420,000
1
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Present Value
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Present Value = PV PV = discount factor C1
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Present Value
Discount Factor = DF = PV of $1
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DF =
1 (1+ r ) t
Discount Factors can be used to compute the present value of any cash flow.
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Valuing an Office Building
Step 1: Forecast cash flows Cost of building = C0 = 400,000 Sale price in Year 1 = C1 = 420,000 Step 2: Estimate opportunity cost of capital If equally risky investments in the capital market offer a return of 5%, then Cost of capital = r = 5%
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Valuing an Office Building
Step 3: Discount future cash flows
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PV =
C1 (1+ r )
=
420 , 000 (1+ .05 )
= 400,000
Step 4: Go ahead if PV of payoff exceeds investment
NPV = 400 ,000 370 ,000 = 30 ,000
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Net Present Value
NPV = PV - required investment C1 NPV = C0 + 1+ r
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Risk and Present Value
Higher risk projects require a higher rate of return Higher required rates of return cause lower PVs
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PV of C1 = $420,000 at 5% 420,000 PV = = 400,000 1 + .05
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Risk and Present Value
PV of C1 = $420,000 at 12% 420,000 PV = = 375,000 1 + .12
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PV of C1 = $420,000 at 5% 420,000 PV = = 400,000 1 + .05
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Risk and Net Present Value
NPV = PV - required investment NPV = 375,000 - 370,000 = $5,000
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Rate of Return Rule
Accept investments that offer rates of return in excess of their opportunity cost of capital
Example In the project listed below, the foregone investment opportunity is 12%. Should we do the project?
profit 420,000 370,000 Return = = = .135 or 13.5% investment 370,000
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Net Present Value Rule
Accept investments that have positive net present value
Example Suppose we can invest $50 today and receive $60 in one year. Should we accept the project given a 10% expected return?
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60 NPV = -50 + = $4.55 1.10
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Opportunity Cost of Capital
Example You may invest $100,000 today. Depending on the state of the economy, you may get one of three possible cash payoffs:
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Economy Payoff
Slump
Normal
Boom
$80,000 110,000 140,000
80,000 + 110,000 + 140,000 Expected payoff = C1 = = $110,000 3
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Opportunity of Cost Capital
Example - continued The stock is trading for $95.65. Next years price, given a normal economy, is forecast at $110 The stocks expected payoff leads to an expected return.
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expected profit 110 95.65 Expected return = = = .15 or 15% investment 95.65
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Opportunity Cost of Capital
Example - continued Discounting the expected payoff at the expected return leads to the PV of the project
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110,000 PV = = $95,650 1.15
NPV requires the subtraction of the initial investment
NPV = 95,650 100,000 = $ 4,350
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Opportunity Cost of Capital
Example - continued Notice that you come to the same conclusion if you compare the expected project return with the cost of capital.
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Expected return =
expected profit 110,000 100,000 = = .10 or 10% investment 100,000
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Investment vs. Consumption
Some people prefer to consume now. Some prefer to invest now and consume later. Borrowing and lending allows us to reconcile these opposing desires which may exist within the firms shareholders.
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Investment vs. Consumption
income in period 1 100 As
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80
60
Some investors will prefer A and others B Bs
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20
20
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Investment vs. Consumption
The grasshopper (G) wants to consume now. The ant (A) wants to wait. But each is happy to invest. Each invests $185,000 and returns $210,000 at the end of the year. G wants to consume now so G borrows $200,000 and repays $210,000 at the end of the year. The existence of capital markets allows G to consume now and still invest with A in the project.
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Investment vs. Consumption
Dollars Next Year 210 A invests $185 now and consumes $210 next year
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194
The grasshopper (G) wants to consume now. The ant (A) wants to wait. But each is happy to invest. Each invests $185,000 and returns $210,000 at the end of the year. G wants to consume now so G borrows $200,000 and repays $210,000 at the end of the year. The existence of capital markets allows G to consume now and still invest with A in the project.
G invests $185 now, borrows $200 and consumes now. Dollars Now
185
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Managers and Shareholder Interests
Tools to Ensure Management Pays Attention to the Value of the Firm
Mangers actions are subject to the scrutiny of the board of directors. Shirkers are likely to find they are ousted by more energetic managers. Financial incentives such as stock options
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Whose Company Is It?
** Survey of 378 managers from 5 countries
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Japan Germany France United Kingdom United States
3 17 22 71 76 40 60 80
97 83 78 29 24
0
The Shareholders All Stakeholders
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100
120
% of responses
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Dividends vs. Jobs
** Survey of 399 managers from 5 countries. Which is more important...jobs or paying dividends?
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Japan Germany France United Kingdom United States
3 40 41
97 60 59 89 89 40 60 80 100 120
11 11 0 20
Dividends Job Security
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Goals of The Corporation
Shareholders desire wealth maximization Do managers maximize shareholder wealth? Mangers have many constituencies stakeholders Agency Problems represent the conflict of interest between management and owners
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Goals of The Corporation
Agency Problem Solutions 1 - Compensation plans 2 - Board of Directors 3 - Takeovers 4 - Specialist Monitoring 5 - Auditors
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Web Resources
Click to access web sites Click Internet connection required www.bankrate.com www.money.cnn.com www.quicken.com www.smartmoney.com
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