Principles of Corporate Finance

Brealey, Myers, Partington and Robinson

1st Australian Edition

 Present Value and The Opportunity

Cost of Capital

Slides by
Matthew Will
and Graham Chapter 2
Partington
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Topics Covered
 Present Value
 Net Present Value
 ROR Rule and the Opportunity Cost of
Capital
 NPV Rule
 Managers and the Interests of Shareholders

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Present Value

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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Present Value

Present Value = PV

PV = discount factor  C1

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Present Value
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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Valuing an Office Building

Step 1: Forecast cash flows
Cost of building = C0 = 350
Sale price in Year 1 = C1 = 400

Step 2: Estimate opportunity cost of capital

If equally risky investments in the capital market
offer a return of 7%, then
Cost of capital = r = 7%

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Valuing an Office Building

Step 3: Discount future cash flows

PV  C1
(1r )  400
(1.07 )  374
Step 4: Go ahead if PV of payoff exceeds investment

NPV  350  374  24

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Net Present Value

NPV = PV - required investment

C1
NPV = C0 
1 r

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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

PV of C1  $400 at 12%
400
PV   357
1  .12
PV of C1  $400 at 7%
400
PV   374
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
 The opportunity cost of capital is the
competitive return that could be earned by
investing in securities with the same risk and
maturity as the investment under
consideration

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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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Net Present Value Rule

 Accept investments that have positive net
present value

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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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Expected and required returns
and equilibrium

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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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Investment vs. Consumption

income in period 1
100

A
80

Some investors will prefer A

60
and others B

40
B

20

 40 60 80 100
income in period 0
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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 at 14%. A
simply invests at 14%, moving up the
red arrow, rather than at the 7% interest
rate. G invests and then borrows at 7%,
thereby transforming $100 into $106.54
of immediate consumption. Because of
the investment, G has $114 next year to
pay off the loan. The investment’s
NPV is $106.54-100 = +6.54

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Investment vs. Consumption

 The grasshopper (G) wants to consume now.
The ant (A) wants to wait. But each is happy
Dollars A invests $100 now
to invests at 14%. A invests at 14%, moving
Later and consumes $114 up the red arrow, rather than at the 7% interest
next year rate. G invests and then borrows at 7%,
thereby transforming $100 into $106.54 of
immediate consumption. Because of the
114 investment, G has $114 next year to pay off
the loan. The investment’s NPV is $106.54
107
-100 = +6.54

G invests $100 now,

borrows $106.54 and
consumes now.

Dollars
100 106.54
Now
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Managers and Maximising NPV

 NPV unlike profit allows for risk and the time
value of money
 Maximising value is not necessarily inconsistent
with ethical behaviour
 Knowing the value consequences tells us the cost of
ethical choices
 Maximising value may not always be in
managers’ interests, but incentives, competition,
and monitoring tend to align managers’ interests
with owners
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