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!