Corporate Finance I

NPV

PD Dr. Karl Ludwig Keiber, Prof. Dr. Olaf Korn

WHU – Otto Beisheim School of Management

Corporate Finance I
7th semester course

1. Net present value in the one-period case

Capital budgeting
2. Net present value in the multiperiod case
under certainty
3. Net present value and capital budgeting
NPV

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NPV

Learning Objectives

• Appreciate the central role of the net present value rule

• Understand the economic reasoning behind it

– Why you do it

• Learn to calculate net present value

– How you do it

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Value and Capital Budgeting

• Investment universe
– real assets
• machinery, real estate
– financial assets
• stocks, bonds

• Investment (financing) objective

– maximization of value
• search for assets whose value exceeds their costs

• Implication
– need a theory of value

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1. Net present value in the one-period case

• What to value?

– Finance view: Cash flows

• How to value?

– Look at financial markets

– Markets for certain cash flows: risk-free borrowing or lending

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1. Net present value in the one-period case

Example:

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1. Net present value in the one-period case

• Present Value: Future cash flow discounted at the risk-free rate

• Net Present Value: Present Value – Costs of investment today

• Net Present Value Rule: Undertake a project if and only if

its net present value is positive

• An investor who follows the net present value rule will be more
wealthy today

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1. Net present value in the one-period case

• Net present value rule rests on

• Basic principle of investment decision making

“A real investment is worth undertaking only if ... [it is ] ...

at least as desirable as what is available
in the financial markets.”

• Financial markets serve as benchmark

• Compare with value of the “tracking portfolio”

of financial instruments ⇒ No-arbitrage valuation

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1. Net present value in the one-period case

Example of the “tracking portfolio” approach:

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1. Net present value in the one-period case

– net present value rule

• “An investment is worth undertaking if it has positive net present value.”

– necessary inputs
• cash flow of investment
• interest rate offered by the financial market

– not necessary
• intertemporal consumption preferences of “investors”
• net present value rule makes all “investors” better off

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1. Net present value in the one-period case

– Who is the investor ?

• Entrepreneur, shareholder, bondholder, manager

– Why are all investors better off ?

• Underlying assumption: firms and individuals can borrow and lend
at the same risk-free rate.

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1. Net present value in the one-period case

Example with two different investors:

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2. Net present value in the multiperiod case

– an investment costs C 0 at date 0

and has cash flows C t at future dates t = 1, …,T
– appropriate interest rate R

• NPV = initial investment + PV(future cash flows)

– initial investment
– present values
• cash flow at date 1

• cash flow at date 2

• cash flow at date t

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2. Net present value in the multiperiod case

– present value of future cash flows

– net present value

– note:

• date t present value factor or

• date t discount factor
– transforms future values into present values

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2. Net present value in the multiperiod case

• Special multiperiod net present value rules

– Growing perpetuity
• definition of perpetuity
– cash flow stream of infinite length
• definition of growth
– cash flows at dates t = 2, 3, …, ∞ obey the law

• PV (growing perpetuity)

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2. Net present value in the multiperiod case

– Special case: perpetuity

• constant cash flow stream
• no growth i.e. growth rate g = 0
• cash flows at dates t = 2, 3, …, ∞ obey the law

• PV (perpetuity)

• Comments: C 1 is date 1 cash flow, not date 0

R > g , otherwise undefined

cash flows occur at the end of a period

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2. Net present value in the multiperiod case

– annuity
• finite cash flow stream of constant cash flows
• cash flows at dates t = 2, 3, …,T obey the law

• idea
– present value of an annuity as difference of the present values of two perpetuities

• PV (annuity)

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2. Net present value in a multiperiod case

– growing annuity
• finite cash flow stream of growing cash flows
• cash flows at dates t = 2, 3, …,T obey the law

• idea
– present value of growing annuity as difference of the present values of two
growing perpetuities

• PV (growing annuity)

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2. Net present value in the multiperiod case

– hints concerning annuities

• annuity starting at future date t ≠ 1

– determine present value at date t − 1
– discount that present value to date 0

• annuity starting at date 0

– determine present value of annuity of length T − 1
– add date 0 cash flow to that present value

• annuity payment occurs once every k periods until T

– determine appropriate per period discount rate
R per period = (1 + R ) k − 1
T according to Rper period
– determine present value of annuity of “length” k

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3. Net present value and capital budgeting

• A few thoughts about cash flows

– general principle

• capital budgeting decisions employ cash flows rather than earnings

– “ ultimately only cash flows generate value, cash flows are the truth ”

• example
– purchase of some real asset with price EUR 100,000
» immediate cash outflow of EUR 100,000
» given straight-line depreciation over 20 years an annual accounting
expense of EUR 5,000 results ⇒ earnings are reduced by EUR 5,000
per year

– concept of incremental cash flow

• difference between the cash flows with the project and the cash flows without the
project are relevant in capital budgeting decisions (after tax cash flows)
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3. Net present value and capital budgeting

– pitfalls in determining incremental cash flows

• sunk costs
– costs which have already occurred in the past
» should be ignored
» do not represent incremental cash flows
– example: cost of a marketing analysis before establishing a new production line

• opportunity costs
– lost cash flows from taking a certain project instead of committing to an
alternative project
» by taking a project the company forgoes other opportunities
» should be taken into account
– example: using a building as storehouse forgoes the cash flows from alternative
uses of the building

• side effects especially erosion

– erosion means transfers of cash flows from an existing project to a new project
» should be taken into account
– example: Mercedes Benz class A, class B, class R vans
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3. Net present value and capital budgeting

• Some reflections about inflation and capital budgeting

– rate of inflation
• quantifies the percentage change of goods’ prices
– positive ⇒ “inflation” ⇒ prices increase
– negative ⇒ “deflation” ⇒ prices decrease
– nominal interest rate
• quantifies the percentage increase in nominal value of an investment
– real interest rate
• quantifies the percentage change in purchasing power

• Should we take inflation into account for capital budgeting?

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