Capital Investment Decisions

2.1 Net Present Value 2.2 Project Valuation in a Riskless World Fishers Principle 2.3 Present Value and Compounding 2.4 Present Value with Special Cash Flows (RWJ Ch 3, 4)

Professor Ho-Mou Wu

Corporate Finance

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Investment Decision
Example 1: Suppose an investment that promises to pay $10,000 in one year is offered for sale for $9,500. Your interest rate is 5%. Should you buy? If you were to be promised $10,000 due in one year when interest rates are at 5-percent, your investment be worth $9,523.81 in todays dollars.

Professor Ho-Mou Wu

Corporate Finance

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2.1 Net Present Value : FV and PV

The amount that a borrower would need to set aside today to to able to meet the promised payment of $10,000 in one year is call the Present Value (PV) of $10,000. Note that $10,000 = $9,523.81(1.05). If you were to invest $10,000 at 5-percent interest for one year, your investment would grow to $10,500 : $10,500 = $10,000(1.05). The total amount due at the end of the investment is call the Future Value (FV).
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Net Present Value

The Net Present Value (NPV) of an investment is the present value of the expected cash flows, less the cost of the investment. Back to Example 1:

: So you should Invest.

Professor Ho-Mou Wu

Corporate Finance

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Net Present Value as the Investment Criterion

In the one-period case, the formula for NPV can be written as: ,where is cash flow at date 1 If we had not undertaken the positive NPV project considered on the last slide, and instead invested our $9,500 elsewhere at 5-percent, our FV would be less than the $10,000 that investment promised and we would be unambiguously worse off in FV terms as well: $9,500(1.05) = $9,975 < $10,000.
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2.2 Project Evaluation in a Riskless World

Why do we use NPV as the investment criterion ? Assume Perfect Capital Market and Two Period
C1 Saver (lending) C1 1+r Y1=1.2m 1 B Y slope = -(1+r) Spender (borrowing) A

C0
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Y0=1m Y1 PV(Y) Y0 (1 r ) Corporate Finance

C0

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(I) Saving (Financing) Decision

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Corporate Finance

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Use PV to Check Feasibility of Consumption plan

Example 2: Is the consumption plan C00.9m and C11.325m feasible? Use the PV formula to evaluate it.
If r10%, 0.9 2.105PV(C)1 : not feasible If r20%, 0.9 2.004PV(C)1 : not feasible If r30%, 0.9 1.919PV(C)1 : feasible!
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2.091PV(Y)

2.000PV(Y)

1.923PV(Y)

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() Investment Opportunities

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Corporate Finance

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Corporate Investment Decision-Making

Consumption at t+1

Positive NPV projects shift the shareholders opportunity set out, which is unambiguously good. All shareholders agree on their preference for positive NPV projects, whether they are borrowers or lenders.

Professor Ho-Mou Wu

Corporate Finance

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() Investment Opportunities with Financial Markets

Financial markets present saving/borrowing C1 opportunities, as represented by the dotted straight line. Suppose the company (farm) chooses D, its owners can then use financial markets for saving or borrowing. Both investors are happier than in (), but D is not the optimal investment plan yet.
B

slope = -(1+r) A E C0 PV(D)

Professor Ho-Mou Wu

Corporate Finance

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Project Valuation in a Riskless World

Y* is the optimal investment plan, which is the one that maximizes NPV(Y)PV(Y)E or PV(Y).
C1 B slope = -(1+r)

Y1

Y*

Perfect capital market (borrowing ratelending rate) is assumed.

Y0

C0 PV(Y)

Professor Ho-Mou Wu

Corporate Finance

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Corporate Investment Decision-Making

In reality, shareholders do not vote on every investment decision faced by a firm and the managers of firms need decision rules to operate by. All shareholders of a firm will be made better off if managers follow the NPV ruleundertake positive NPV projects and reject negative NPV projects.

Professor Ho-Mou Wu

Corporate Finance

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Optimal Investment Plan

Net Present Value NPV

PV(Y)E
Therefore, the best investment plan is the one that maximizes NPV(Y); and the best investment plan is independent of investors preferences.

PV

NPV

Professor Ho-Mou Wu

Corporate Finance

2-13

Fishers Separation Principle

Given perfect capital market and certainty, the optimal investment plan is the one that maximizes the net present value of available production plans, without regard to the individuals subjective preferences that enter into their consumption/saving decisions. (Irving Fisher) This is the basis for using the present value as the evaluation criterion. Separation of investment and financing decisions Separation of ownership and management.
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Why do we use NPV or PV as investment criterion

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Corporate Finance

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NPV as Investment Criterion

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Corporate Finance

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2.3 Present Value and Compounding

How much would an investor have to set aside today in order to have $20,000 five years from now if the current rate is 15%?

PV
0 1 2 3 4

$20,000
5

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Corporate Finance

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How Long is the Wait?

Example 5: If we deposit $5,000 today in an account paying 10%, how long does it take to grow to $10,000?

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Corporate Finance

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What Rate Is Enough?

Example 6: Assume the total cost of a college education will be $50,000 when your child enters college in 12 years. You have $5,000 to invest today. What rate of interest must you earn on your investment to cover the cost of your childs education?

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Corporate Finance

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2.4 PV with Special Cash Flows

Perpetuity
A constant stream of cash flows that lasts forever.

Growing perpetuity
A stream of cash flows that grows at a constant rate forever.

Annuity
A stream of constant cash flows that lasts for a fixed number of periods.

Growing annuity
A stream of cash flows that grows at a constant rate for a fixed number of periods.
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Perpetuity
A constant stream of cash flows that lasts forever. C 0 1 C 2 C 3

The formula for the present value of a perpetuity is:

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Growing Perpetuity
A growing stream of cash flows that lasts forever. C 0 1 C(1+g) 2 C (1+g)2 3

The formula for the present value of a growing perpetuity is:

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Corporate Finance

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Annuity
A constant stream of cash flows with a fixed maturity. C C C C

0 1 2 3 T

The formula for the present value of an annuity is:

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Corporate Finance

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Growing Annuity
A growing stream of cash flows with a fixed maturity. C(1+g) C (1+g)2 C(1+g)T-1 C

0 1 2 3 T

The formula for the present value of a growing annuity:

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Corporate Finance

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What Is a Firm Worth?

Conceptually, a firm should be worth the present value of the firms cash flows. The tricky part is determining the size, timing and risk of those cash flows : we will probe further in later class..

Professor Ho-Mou Wu

Corporate Finance

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