Chapter 2 Principles of Corporate Finance Eighth Edition Present Value, the Objectives of The Firm,...

Chapter 2

Principles of

Corporate FinanceEighth Edition

Present Value, the Objectives of The Firm,

and Corporate Governance

Slides by

Matthew Will

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved

McGraw-Hill/Irwin


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Topics Covered

Introduction to Present ValueFoundations of the Net Present Value

RuleCorporate Goals and Corporate

Governance


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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


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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.


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Future Values

Future Value of $100 = FV

FV r t $100 ( )1


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Future Values

FV r t $100 ( )1

Example - FV

What is the future value of $5400,000 if interest is compounded annually at a rate of 5% for one year?

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


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Present Value

1factordiscount =PV

PV=ValuePresent

C


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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( )


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Valuing an Office Building

Step 1: Forecast cash flows

Cost of building = C0 = 400

Sale price in Year 1 = C1 = 420

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%


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Valuing an Office Building

Step 3: Discount future cash flows

Step 4: Go ahead if PV of payoff exceeds investment

400)05.1(420

)1(1 r

CPV

30370400 NPV


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Net Present Value

r

C

1C=NPV

investment required-PV=NPV

10


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Risk and Present Value

Higher risk projects require a higher rate of return

Higher required rates of return cause lower PVs

400.051

420PV

5%at $420 C of PV 1


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Risk and Present Value

400.051

420PV

5%at $420 C of PV 1

375.121

420PV

12%at $420 C of PV 1


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Risk and Net Present Value

$5,000

370,000-75,0003=NPV

investment required-PV=NPV


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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


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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


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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


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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


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Example - continued

Discounting the expected payoff at the expected return leads to the PV of the project

650,95$1.15

110,000PV


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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


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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.


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A

B

100

80

60

40

20

40 60 80 100income in period 0

income in period 1

Some investors will prefer A

and others B


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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.


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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.


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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


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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


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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?


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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


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Goals of The Corporation

Agency Problem Solutions

1 - Compensation plans

2 - Board of Directors

3 - Takeovers

4 - Specialist Monitoring

5 - Auditors


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Web Resources

www.smartmoney.com

www.moneychimp.com/features/rule72.htm

www.mhhe.com/business/finance/corpfinonline

www.bankrate.com/brm/default.asp

www.financenter.com

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