SEC02 - UNIVERSITY OF PENNSYLVANIA THE WHARTON SCHOOL...

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UNIVERSITY OF PENNSYLVANIA THE WHARTON SCHOOL LECTURE NOTES FNCE 601 FINANCIAL ANALYSIS Franklin Allen Fall 2003 QUARTER 1 - WEEKS 1 & 2 Th: 9/4/03 and Tu: 9/9/03 Copyright 2003 by Franklin Allen
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FNCE 601 - Section 2 - Page 1 PART II. INVESTMENT DECISIONS Section 2: The Objective Function for Corporations Read Chapter 2 in BM Motivation Example Suppose you are at a GM shareholders’ meeting. Three of the shareholders there have very different ideas about what the firm should do. Old lady: Wants money now. Wants GM to invest in large cars since this would yield a quick profit. Little Boy’s trust Wants money a long way in the future. Wants GM to invest in fund representative building electric cars. Pension fund Wants money in the medium term. Thinks there will be a very representative serious oil crisis some time in that period. Recommends that GM build small cars. What should GM do? We shall soon be in a position to answer this question. Net Present Value Suppose that a firm has a project. To keep it very simple, assume the project has a cost now and generates a revenue one year from now. The net present value or the NPV as it is known is net amount generated by the project all evaluated in terms of today°s dollars. NPV = - Cost + PV(Revenue) We can think of cost as a negative cash flow and denote it C 0 since it occurs now, at time 0, i.e.,
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FNCE 601 - Section 2 - Page 2 C 0 = - Cost It’s important to note that C 0 is a negative number usually. If something costs $2M, then C 0 = -2M. Also suppose the revenue one year from now is C 1 r 1 C ) venue (Re PV 1 + = Substituting we have r 1 C C NPV 1 0 + + = What NPV is measuring is the net amount of wealth in terms of dollars today that the project creates. Now, the NPV rule states that if a project has a positive NPV, we should accept it; if it’s negative we should reject it. NPV Rule: Accept project if NPV > 0. For example, suppose C 1 = 110, r = 10%, and C 0 = - 90. Should we accept? Yes, since NPV = +10. Suppose C 0 = - 105. Should we accept? No, since NPV = -5. Using the NPV rule always leads to an increase in NPV and hence is equivalent to maximizing NPV. In this section we’re going to look at the NPV rule for an individual. Then we’ll show why it’s a valid rule for a corporation even though the corporation may be owned by many different types of people. We’re going to do this by considering a simple example.
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FNCE 601 - Section 2 - Page 3 Example Bill Ross has inherited $1M. He grew up in Europe and has developed a real aversion to work, which he completely detests. He therefore plans to use his inheritance to finance himself for the rest of his life. For simplicity we’ll divide his life into two periods, youth and old age. Also, we’re going to assume that there is only one financial institution, a bank, which lends and borrows at a rate of 20%, so that for every dollar deposited in youth $1.20 is received in old age.
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