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

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 Principles of Corporate Finance
Brealey and Myers Sixth Edition

 Present Value and The Opportunity

Cost of Capital

Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000

 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

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 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.

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 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?
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• 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.

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 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.

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 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.

PV = discount factor  C1

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 Continue
Present Value Discount Factor
Value today of Present value of
a future cash a $1 future
flow. payment.

Discount Rate
Interest rate used
to compute
present values of
future cash flows.
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 Continue
Discount Factor = DF = PV of $1

DF  1
(1 r ) t

Discount Factors can be used to compute the present value of

any cash flow.

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 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?
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 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.

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 Continue
Step 2: Estimate opportunity cost of capital
If equally risky investments in the capital market
offer a return of 7%, how much would you have
to invest in them in order to receive $400,000 at
the end of the year?

Lets find out!

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 Valuing an Office Building
Step 3: Discount future cash flows (,000)

C1
PV  (1r )  (1400
.07 )  374
• Since the property will be worth $400,000 in a
year, investors would be willing to pay
$374,000 for it today.

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 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.

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 Net Present Value

NPV = PV - required investment

C1
NPV = C0 
1 r

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 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 contribution
to value.
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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.

PV of C1  $400 at 7%
400
PV   374
1  .07
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 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.

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 Risk and Present Value
PV of C1  $400 at 12%
400
PV   357
1  .12
Re-compute; PV of C1  $400 at 7%
NPV = PV-350 400
PV   374
=$7 1  .07
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 Rate of Return Rule
• Accept investments that offer rates of return
in excess of their opportunity cost of capital

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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?

profit 400,000  350,000

Return    .14 or 14%
investment 350,000

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 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.

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 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?

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 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.

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 Continue
Step 2: Estimate opportunity cost of capital
A 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!

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 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.

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 Valuing an Motel Building
Step 3: Discount future cash flows (,000)

C1
PV  (1r )  1500
(1.10 )  1364
• Since the property will be worth $1500,000 in a
year, investors would be willing to pay $1364,000
for it today

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 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.
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 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.

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 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)

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 Continue
• It follows that:
NPV = C0 + {C1/(1 + r)}

NPV = -INV + {[INV(1 + x)]/(1 + r)}

NPV = INV {[(1 + x)/(1 + r)] – 1}

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 Continue
a. When x equals r, then:
[(1 + x)/(1 +r)] – 1 = 0
and NPV is zero.

b. When x exceeds r, then:

[(1 + x)/(1 + r)] – 1 > 0
and NPV is positive.

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 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

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 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.

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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?

60
NPV = -50 +  $ 4 .55
1.10
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 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

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