Chapter 2Principles

of

Corporate

Finance

Ninth Edition

Present Value, The

Objectives of The Firm,

and Corporate Governance

Slides by

Matthew Will

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reservedMcGraw Hill/Irwin

2- 2

Topics Covered

Introduction to Present Value

Foundations of the Net Present Value

Rule

Corporate Goals and Corporate

Governance

2- 3

Present and Future Value

Present Value

Value today of a

future cash

flow.

Future Value

Amount to which an

investment will grow

after earning interest

2- 4

Discount Factors and Rates

Discount Rate

Interest rate used

to compute

present values of

future cash flows. Discount Factor

Present value of

a $1 future

payment.

2- 5

Future Values

Future Value of $100 = FV

FV r t$100 ( )1

2- 6

Future Values

FV r t$100 ( )1

Example - FV

What is the future value of $100 if interest is

compounded annually at a rate of 6% for five years?

82.133$)06.1(100$ 5FV

2- 7

Future Values

FV r t$100 ( )1

Example - FV

What is the future value of $400,000 if interest is

compounded annually at a rate of 5% for one year?

000,420$)05.1(000,400$ 1FV

2- 8

Present Value

1factordiscount =PV

PV=ValuePresent

C

2- 9

Present Value

Discount Factor = DF = PV of $1

Discount Factors can be used to compute the present value of

any cash flow.

DFr t

1

1( )

2- 10

Valuing an Office Building

Step 1: Forecast cash flows

Cost of building (construction + cost of land) = C0 = -370,000

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%

2- 11

Valuing an Office Building

Step 3: Discount future cash flows

Step 4: Go ahead if PV of payoff exceeds investment

000,400)05.1(

000,420

)1(1

r

CPV

00030

000370000400

,

,,NPV

2- 12

Net Present Value

r

C

1C=NPV

investment required-PV=NPV

10

2- 13

Risk and Present Value

Higher risk projects require a higher rate of

return

Higher required rates of return cause lower

PVs

000,400.051

420,000PV

5%at $420,000 C of PV 1

2- 14

Risk and Present Value

000,400.051

420,000PV

5%at $420,000 C of PV 1

000,375.121

420,000PV

12%at $420,000 C of PV 1

2- 15

Risk and Net Present Value

$5,000

370,000-75,0003=NPV

investment required-PV=NPV

2- 16

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?

13.5%or .135370,000

370,000420,000

investment

profitReturn

2- 17

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?

55.4$1.10

60+-50=NPV

2- 18

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:

140,000110,000$80,000Payoff

BoomNormalSlumpEconomy

000,110$3

000,140000,110000,80C payoff Expected 1

2- 19

Opportunity Cost of Capital

Example - continued

The stock is trading for $95.65. Next year’s price,

given a normal economy, is forecast at $110

The stocks expected payoff leads to an expected

return.

15%or 15.65.95

65.95110profit expectedreturn Expected

investment

2- 20

Opportunity Cost of Capital

Example - continued

Discounting the expected payoff at the expected

return leads to the PV of the project

NPV requires the subtraction of the initial

investment

650,95$1.15

110,000PV

350,4$000,100650,95NPV

2- 21

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.

10%or 10.000,100

000,100000,110profit expectedreturn Expected

investment

2- 22

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 firm’s shareholders.

2- 23

Investment vs. Consumption

A n

B n

100

80

60

40

20

40 60 80 100income in period 0

income in period 1

Some investors will prefer A

and others B

2- 24

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.

2- 25

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.

185 200 Dollars

Now

Dollars

Next Year

210

194

A invests $185 now

and consumes $210

next year

G invests $185 now,

borrows $200 and

consumes now.

2- 26

Managers and Shareholder Interests

Tools to Ensure Management Pays

Attention to the Value of the Firm

– Manger’s 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

2- 27

Whose Company Is It?

24

29

78

83

97

76

71

22

17

3

0 20 40 60 80 100 120

United States

United Kingdom

France

Germany

Japan

% of responsesThe Shareholders

All Stakeholders

** Survey of 378 managers from 5 countries

2- 28

Dividends vs. Jobs

11

11

59

60

97

89

89

41

40

3

0 20 40 60 80 100 120

United States

United Kingdom

France

Germany

Japan

% of responsesDividends

Job Security

** Survey of 399 managers from 5 countries. Which is more important...jobs or

paying dividends?

2- 29

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

2- 30

Goals of The Corporation

Agency Problem Solutions

1 - Compensation plans

2 - Board of Directors

3 - Takeovers

4 - Specialist Monitoring

5 - Auditors

2- 31

NEXT LECTURE

Calculating Present Values

Multiple time-periods

Perpetuities

Annuities

Growing annuities

Bring Calculators!