2- 1

Future Values

Future Value of Rs.100 = FV

FV  Rs.100  (1  r ) t

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 2- 2

Future Values

FV  Rs.100  (1  r ) t

Example - FV
What is the future value of Rs.400,000 if interest is
compounded annually at a rate of 5% for one year?

1
F V = R s .4 0 0 , 0 0 0 ´ (1 + .0 5 ) = R s .4 2 0 , 0 0 0

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 2- 3

Present Value

Present Value = PV

PV = discount factor  C1

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 2- 4

Present Value

Discount Factor = DF = PV of Rs.1

DF  1
(1 r ) t

Discount Factors can be used to compute the present value of

any cash flow.

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 2- 5

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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 2- 6

Valuing an Office Building

Step 3: Discount future cash flows

PV  C1
(1r )  420
(1.05 )  400
Step 4: Go ahead if PV of payoff exceeds investment

NPV  400  370  30

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 2- 7

Net Present Value

NPV = PV - required investment

C1
NPV = C0 
1 r

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 2- 8

Risk and Present Value

 Higher risk projects require a higher rate of
return
 Higher required rates of return cause lower
PVs

PV of C1  Rs.420 at 5%
420
PV   400
1  .05
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 2- 9

Risk and Present Value

PV of C1  Rs.420 at 12%
420
PV   375
1  .12

PV of C1  Rs.420 at 5%
420
PV   400
1  .05
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 2- 10

Risk and Net Present Value

NPV=PV-required investment

NPV=375,000-370,000
 Rs.5,000

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 2- 11

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?

p ro fit 4 2 0 ,0 0 0  3 7 0 ,0 0 0
R e tu rn    .1 3 5 o r 1 3 .5 %
in v e s tm e n t 3 7 0 ,0 0 0

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 2- 12

Net Present Value Rule

 Accept investments that have positive net
present value

Example
Suppose we can invest Rs.50 today and receive
Rs.60 in one year. Should we accept the project
given a 10% expected return?
60
N P V = -5 0 + = R s .4 .5 5
1 .1 0
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 2- 13

Opportunity Cost of Capital

Example
You may invest Rs.100,000 today. Depending on
the state of the economy, you may get one of three
possible cash payoffs:

E conom y S lu m p N o rm a l B oom
P a y o ff R s .8 0 ,0 0 0 1 1 0 ,0 0 0 1 4 0 ,0 0 0

80,000 +110,000 +140,000

E x p e c te d p a y o ff = C 1 = = R s .1 1 0 , 0 0 0
3

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 2- 14

Opportunity Cost of Capital

Example - continued
The stock is trading for Rs.95.65. Next year’s
price, given a normal economy, is forecast at
Rs.110

The stocks expected payoff leads to an expected

return.
e x p e c te d p r o f it 1 1 0  9 5 .6 5
E x p e c te d re tu rn    .1 5 o r 1 5 %
in v e s tm e n t 9 5 .6 5

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 2- 15

Opportunity Cost of Capital

Example - continued
Discounting the expected payoff at the expected
return leads to the PV of the project

1 1 0 ,0 0 0
PV = = R s .9 5 , 6 5 0
1 .1 5

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 2- 16

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.

e x p e c te d p r o f it 1 1 0 ,0 0 0  1 0 0 ,0 0 0
E x p e c te d re tu rn    .1 0 o r 1 0 %
in v e s tm e n t 1 0 0 ,0 0 0

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 2- 17

Investment vs. Consumption

The grasshopper (G) wants to
consume now. The ant (A) wants to
wait. But each is happy to invest.
Each invests Rs.185,000 and returns
Rs.210,000 at the end of the year. G
wants to consume now so G borrows
Rs.200,000 and repays Rs.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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 2- 18

Investment vs. Consumption

 The grasshopper (G) wants to consume
A invests Rs.185 now now. The ant (A) wants to wait. But
Rupees
and consumes Rs.210 each is happy to invest. Each invests
Next Year Rs.185,000 and returns Rs.210,000 at the
next year
210 end of the year. G wants to consume now
so G borrows Rs.200,000 and repays
Rs.210,000 at the end of the year. The
existence of capital markets allows G to
194 consume now and still invest with A in
the project.
G invests Rs.185 now,
borrows Rs.200 and
consumes now.

Rupees
185 200
Now

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