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Last Study Topics• What Is A Corporation?- All large and medium-sized businesses are organized as
corporations.• The Role of The Financial Manager- Capital Budgeting vs Financing Decision.• Who Is The Financial Manager?- Anyone responsible for a significant investment or
financing decisions.• Separation of Ownership and Management• Financial Markets
11/14/2014 Instructor: Mr. Wajid Shakeel Ahmed 1
Present Value and The Opportunity Cost of Capital
Principles of Corporate FinanceBrealey and Myers Sixth Edition
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
Topics Covered
• Present Value (PV)• Net Present Value (NPV)• NPV Rule• Rate Of Return Rule• Opportunity Cost of Capital• Managers and the Interests of Shareholders
11/14/2014 3Instructor: Mr. Wajid Shakeel Ahmed
Introduction• COMPANIES INVEST IN a variety of real assets.- Tangible Assets: such as plant and machinery.- Intangible Assets: such as management
contracts and patents.• Object of investment is to find real assets that
are worth more than they cost.• Companies are always searching for assets
that are worth more to them than to others.
11/14/2014 Instructor: Mr. Wajid Shakeel Ahmed 4
Continue• Suppose you own a warehouse.• The odds are that your appraiser’s estimate of
its value will be within a few percent of what the building would actually sell for.
• The appraiser’s stock-in-trade is knowledge of the prices at which similar properties have recently changed hands.
• Problem of valuing real estate is simplified by the existence of an active market. Or Is it not?
11/14/2014 Instructor: Mr. Wajid Shakeel Ahmed 5
Continue• Answer to that would be;• First, it is important to know how asset values
are reached in an active market. • Second, it is important to understand why
that warehouse is worth, say, $250,000 and not a higher or lower figure.
• Thirdly, the market for most corporate assets is pretty thin.
11/14/2014 Instructor: Mr. Wajid Shakeel Ahmed 6
Continue
• In other words, you need a theory of value.• Should you invest to build a new office
building in the hope of selling it at a profit next year?
• Finance theory endorses investment if net present value is positive, that is, if the new building’s value today exceeds the required investment.
11/14/2014 Instructor: Mr. Wajid Shakeel Ahmed 7
Understanding the Present Value
• The present value of $400,000 one year from now must be less than $400,000.
• “A dollar today is worth more than a dollar tomorrow” - first basic principle of finance.
11/14/2014 Instructor: Mr. Wajid Shakeel Ahmed 8
1factordiscount =PV C
Continue
Present Value
Value today of a future cash
flow.
Discount Rate
Interest rate used to compute
present values of future cash flows.
Discount Factor
Present value of a $1 future payment.
11/14/2014 9Instructor: Mr. Wajid Shakeel Ahmed
Continue
Discount Factor = DF = PV of $1
Discount Factors can be used to compute the present value of any cash flow.
DFr t
1
1( )
11/14/2014 10Instructor: Mr. Wajid Shakeel Ahmed
Case: Office Building
• Warehouse has burned down. You consider rebuilding, but your real estate adviser suggests putting up an office building instead. The construction cost would be $300,000, and there would also be the cost of the land, which might otherwise be sold for $50,000. new building would fetch $400,000 if you sold it after an year. Is it worth to go ahead with the investment plan? or not?
11/14/2014 Instructor: Mr. Wajid Shakeel Ahmed 11
Valuing an Office Building
Step 1: Forecast cash flows (,000)
Cost of building = C0 = $350
Sale price in Year 1 = C1 = $400
• Assuming for the moment that the$400,000 payoff is a sure thing.
11/14/2014 12Instructor: Mr. Wajid Shakeel Ahmed
ContinueStep 2: Estimate opportunity cost of capitalIf equally risky investments in the capital marketoffer a return of 7%, how much would you haveto invest in them in order to receive $400,000 at the end of the year?
Lets find out!
11/14/2014 Instructor: Mr. Wajid Shakeel Ahmed 13
Valuing an Office Building
Step 3: Discount future cash flows (,000)
• Since the property will be worth $400,000 in a year, investors would be willing to pay $374,000 for it today.
374)07.1(400
)1(1 r
CPV
11/14/2014 14Instructor: Mr. Wajid Shakeel Ahmed
Continue
• We have discounted expected payoffs by the rate of return offered by equivalent investment alternatives in the capital market, i.e. offer a return of 7%.
• This rate of return is often referred to as the discount rate, hurdle rate, or opportunity cost of capital.
11/14/2014 Instructor: Mr. Wajid Shakeel Ahmed 15
Net Present Value
r
C
1C=NPV
investment required-PV=NPV
10
11/14/2014 16Instructor: Mr. Wajid Shakeel Ahmed
Continue
Step 4: Go ahead if PV of payoff exceeds investment
• NPV = PV - required investment = 374,000 - 350,000 = $24,000.
• In other words, your office development is worth more than it costs—it makes a net contributionto value.
11/14/2014 Instructor: Mr. Wajid Shakeel Ahmed 17
Risk and Present Value• Higher risk projects require a higher rate of
return.• Higher required rates of return cause lower
PVs.
374.071
400PV
7%at $400 C of PV 1
11/14/2014 18Instructor: Mr. Wajid Shakeel Ahmed
Risk and Present Value
• Suppose you believe the project is as risky as investment in the stock market and that stock market investments are forecasted to return 12 percent.
• Then 12 percent becomes the appropriate opportunity cost of capital.
• That is what you are giving up by not investing in equally risky securities.
11/14/2014 Instructor: Mr. Wajid Shakeel Ahmed 19
Risk and Present Value
374.071
400PV
7%at $400 C of PV 1
357.121
400PV
12%at $400 C of PV 1
11/14/2014 20Instructor: Mr. Wajid Shakeel Ahmed
Re-compute;
NPV = PV-350 =$7
Rate of Return Rule• Accept investments that offer rates of return
in excess of their opportunity cost of capital
11/14/2014 21Instructor: Mr. Wajid Shakeel Ahmed
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?
14%or .14350,000
350,000400,000
investment
profitReturn
11/14/2014 22Instructor: Mr. Wajid Shakeel Ahmed
Explanation
• One cannot be certain about future values of office buildings.
• The $400,000 represents the best forecast, but it is not a sure thing.
• A safe dollar is worth more than a risky one.• Most investors avoid risk when they can do so
without sacrificing return.
11/14/2014 Instructor: Mr. Wajid Shakeel Ahmed 23
Case: Motel Building
• Aparcel of land costs $500,000. For an additional $800,000 you can build a motel on the property. The land and motel should be worth $1,500,000 next year. Suppose that common stocks with the same risk as this investment offer a 10 percent expected return. Would you construct the motel? Why or why not?
11/14/2014 Instructor: Mr. Wajid Shakeel Ahmed 24
Valuing a Motel Building
Step 1: Forecast cash flows (,000)
Cost of building = C0 = $1300
Sale price in Year 1 = C1 = $1500
• Assuming for the moment that the$1500,000 payoff is a sure thing.
11/14/2014 25Instructor: Mr. Wajid Shakeel Ahmed
ContinueStep 2: Estimate opportunity cost of capitalA Common Stock with a same risk as this investments in the capital market offer a return of 10%, how much would you have to invest in them in order to receive $1500,000 at the end Of the year?
Lets find out!
11/14/2014 Instructor: Mr. Wajid Shakeel Ahmed 26
Continue
• To calculate present value, we discount expected payoffs by the rate of return offered by equivalent investment alternatives in the capital market, i.e. offer a return of 10%.
• This rate of return is often referred to as the discount rate, hurdle rate, or opportunity cost of capital.
11/14/2014 Instructor: Mr. Wajid Shakeel Ahmed 27
Valuing an Motel Building
Step 3: Discount future cash flows (,000)
• Since the property will be worth $1500,000 in a year, investors would be willing to pay $1364,000 for it today
1364)10.1(1500
)1(1 r
CPV
11/14/2014 28Instructor: Mr. Wajid Shakeel Ahmed
Continue
Step 4: Go ahead if PV of payoff exceeds investment
• NPV = PV - required investment = 1364,000 - 1300,000 = $64,000.
• In other words, your motel development is worth more than it costs—it makes a net contribution to value.
11/14/2014 Instructor: Mr. Wajid Shakeel Ahmed 29
Alternative
• we can compute r as follows:
r = ($1,500,000/$1,300,000) – 1 = 0.1538 = 15.38%
• Since - Rate of Return is > Cost of Capital, you would still construct the motel.
11/14/2014 Instructor: Mr. Wajid Shakeel Ahmed 30
Understanding NPV and ROR
• Let INV = investment required at time t = 0 (i.e., INV = -C0) and let x = rate of return.
• Then x is defined as:x = (C1 – INV)/INV
• Therefore:C1 = INV(1 + x)
11/14/2014 Instructor: Mr. Wajid Shakeel Ahmed 31
Continue
• It follows that:NPV = C0 + {C1/(1 + r)}
NPV = -INV + {[INV(1 + x)]/(1 + r)}
NPV = INV {[(1 + x)/(1 + r)] – 1}
11/14/2014 Instructor: Mr. Wajid Shakeel Ahmed 32
Continue
a. When x equals r, then:[(1 + x)/(1 +r)] – 1 = 0and NPV is zero.
b. When x exceeds r, then:[(1 + x)/(1 + r)] – 1 > 0and NPV is positive.
11/14/2014 Instructor: Mr. Wajid Shakeel Ahmed 33
Case: Pakistan Treasury security
• What is the net present value of a firm’s investment in a Pakistan Treasury security with the face value of Rs. 1000 yielding 5 percent and maturing in one year?
• Solution: NPV = C0 + [C1/(1 + r)] = Rs. -1000 + (1050/1.05) = Rs. 0
11/14/2014 Instructor: Mr. Wajid Shakeel Ahmed 34
Explanation
• This is not a surprising result, because 5 percent is the opportunity cost of capital, i.e., 5 percent is the return available in the capital market.
• If any investment earns a ‘rate of return’ equal to the ‘opportunity cost of capital’, the NPV of that investment is zero.
11/14/2014 Instructor: Mr. Wajid Shakeel Ahmed 35
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
11/14/2014 36Instructor: Mr. Wajid Shakeel Ahmed
Summary• Present Value (PV)– “A dollar today is worth more than a dollar
tomorrow”
• Net Present Value (NPV)– If your investment makes a net contribution to
value
• NPV Rule• Rate Of Return Rule
11/14/2014 Instructor: Mr. Wajid Shakeel Ahmed 37