Principles of Corporate Finance Brealey and Myers u

Principles of Corporate Finance Brealey and Myers u Sixth Edition Present Value and The Opportunity Cost of Capital Slides by Matthew Will Irwin/Mc. Graw Hill Chapter 2 ©The Mc. Graw-Hill Companies, Inc. , 2000

2 - 2 Topics Covered w Present Value w Net Present Value w NPV Rule w ROR Rule w Opportunity Cost of Capital w Managers and the Interests of Shareholders Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

2 - 3 Present Value Discount Factor Value today of a future cash flow. Present value of a $1 future payment. Discount Rate Interest rate used to compute present values of future cash flows. Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

2 - 4 Irwin/Mc. Graw Hill Present Value ©The Mc. Graw-Hill Companies, Inc. , 2000

2 - 5 Present Value Discount Factor = DF = PV of $1 Discount Factors can be used to compute the present value of any cash flow. Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

2 - 6 Valuing an Office Building Step 1: Forecast cash flows Cost of building = C 0 = 350 Sale price in Year 1 = C 1 = 400 Step 2: Estimate opportunity cost of capital If equally risky investments in the capital market offer a return of 7%, then Cost of capital = r = 7% Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

2 - 7 Valuing an Office Building Step 3: Discount future cash flows Step 4: Go ahead if PV of payoff exceeds investment Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

2 - 8 Irwin/Mc. Graw Hill Net Present Value ©The Mc. Graw-Hill Companies, Inc. , 2000

2 - 9 Risk and Present Value w Higher risk projects require a higher rate of return. w Higher required rates of return cause lower PVs. Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

2 - 10 Irwin/Mc. Graw Hill Risk and Present Value ©The Mc. Graw-Hill Companies, Inc. , 2000

2 - 11 Rate of Return Rule w Accept investments that offer rates of return in excess of their opportunity cost of capital Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

2 - 12 Rate of Return Rule w 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? Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

2 - 13 Net Present Value Rule w Accept investments that have positive net present value Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

2 - 14 Net Present Value Rule w 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? Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

2 - 15 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: Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

2 - 16 Opportunity Cost of Capital Example - continued The stock is trading for $95. 65. Depending on the state of the economy, the value of the stock at the end of the year is one of three possibilities: Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

2 - 17 Opportunity Cost of Capital Example - continued The stocks expected payoff leads to an expected return. Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

2 - 18 Opportunity Cost of Capital Example - continued Discounting the expected payoff at the expected return leads to the PV of the project. Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

2 - 19 Investment vs. Consumption w 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. Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

2 - 20 Investment vs. Consumption income in period 1 100 An 80 Some investors will prefer A and others B 60 40 Bn 20 20 Irwin/Mc. Graw Hill 40 60 income in period 0 80 100 ©The Mc. Graw-Hill Companies, Inc. , 2000

2 - 21 Investment vs. Consumption The grasshopper (G) wants to consume now. The ant (A) wants to wait. But each is happy to invest. A prefers to invest 14%, moving up the red arrow, rather than at the 7% interest rate. G invests and then borrows at 7%, thereby transforming $100 into $106. 54 of immediate consumption. Because of the investment, G has $114 next year to pay off the loan. The investment’s NPV is $106. 54 -100 = +6. 54 Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

2 - 22 Investment vs. Consumption w Dollars Later A invests $100 now and consumes $114 next year 114 107 The grasshopper (G) wants to consume now. The ant (A) wants to wait. But each is happy to invest. A prefers to invest 14%, moving up the red arrow, rather than at the 7% interest rate. G invests and then borrows at 7%, thereby transforming $100 into $106. 54 of immediate consumption. Because of the investment, G has $114 next year to pay off the loan. The investment’s NPV is $106. 54100 = +6. 54 G invests $100 now, borrows $106. 54 and consumes now. 100 Irwin/Mc. Graw Hill 106. 54 Dollars Now ©The Mc. Graw-Hill Companies, Inc. , 2000

2 - 23 Managers and Shareholder Interests w Tools to Ensure Management Responsiveness Subject managers to oversight and review by specialists. è Internal competition for top level jobs that are appointed by the board of directors. è Financial incentives such as stock options. è Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000