Corporate Finance 2-1 © Professor Ho-Mou Wu

Capital Investment Decisions
Capital Investment Decisions
2.1 Net Present Value
2.2 Project Valuation in a Riskless World
Fisher’s Principle
2.3 Present Value and Compounding
2.4 Present Value with Special Cash Flows
(RWJ Ch 3, 4)
Corporate Finance 2-2
© Professor Ho-Mou Wu
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 today’s dollars.
05 . 1
000 , 10 $
81 . 523 , 9 $ ·
Corporate Finance 2-3
© Professor Ho-Mou Wu
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).
Corporate Finance 2-4
© Professor Ho-Mou Wu
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.
81 . 523 , 9 $ 500 , 9 $
05 . 1
000 , 10 $
500 , 9 $
+ − ·
+ − ·
NPV
NPV
: So you should Invest.
81 . 23 $ · NPV
Back to Example 1:
Corporate Finance 2-5
© Professor Ho-Mou Wu
Net Present Value as the Investment Criterion
In the one-period case, the formula for NPV can be
written as:
PV Cost NPV + − ·
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.
r
CF
PV
+
·
1
1
,where is cash flow at date 1
1
CF
Corporate Finance 2-6
© Professor Ho-Mou Wu
2.2 Project Evaluation in a Riskless World





C
0
C
0
C
1
C
1
Y
1
=1.2m
Y
0
=1m
Saver (lending)
B
Spender (borrowing)
A
Y

) r 1 (
Y
Y ) Y ( PV
1
0
+
+ ·
1
1+r
slope = -(1+r)
Why do we use NPV as the investment criterion ?
Assume Perfect Capital Market and Two Period
Corporate Finance 2-7
© Professor Ho-Mou Wu
(I) Saving (Financing) Decision
Income Y



Consumption C


Is C

(C
0
, C
1
) feasible?
There is only one interest rate in the perfect capital
market.
Saver (C
0

1m)

C
1

1.2

(1

C
0
)(1

r)
Spender (C
0

1m)

C
1

1.2

(C
0

1)(1

r)




Same equation C
1

Y
1

(Y
0

C
0
)(1

r)

¹
'
¹
·
·
m 2 . 1 Y
m 1 Y
1
0
.
,
) r 1 (
Y
Y
) r 1 (
C
C or
1
0
1
0
feasible is C then PV(Y), PV(C) If ≤
+
+ ≤
+
+
¹
'
¹
·
·
m 325 . 1 C
m 9 . 0 C
1
0
Corporate Finance 2-8
© Professor Ho-Mou Wu
Use PV to Check Feasibility of Consumption plan
Example 2:
Is the consumption plan C
0
=0.9m and C
1
=1.325m
feasible?
Use the PV formula to evaluate it.
If r =10%, 0.9 + =2.105 =PV(C) >1 + =2.091
=PV(Y)
: not feasible
If r =20%, 0.9 + =2.004 =PV(C) >1 + =2.000
=PV(Y)
: not feasible
If r =30%, 0.9 + =1.919 =PV(C) <1 + =1.923
=PV(Y)
: feasible!
1 . 1
325 . 1
2 . 1
325 . 1
3 . 1
325 . 1
1 . 1
2 . 1
2 . 1
2 . 1
3 . 1
2 . 1
Corporate Finance 2-9
© Professor Ho-Mou Wu
( ) Ⅱ Investment Opportunities

Real Investment opportunities
transform input into output


Consider a farmer with wheat
(endowment) E that can be
used either for consumption or as
input to produce output next period.
The spender and saver will not agree
on the choice of the best investment
plan (A

B).
Both consume what they produce (Y
0
,
Y
1
),
where E

Y
0

input and Y
1

output.

C
1
B
Saver
Spender
A
Y
0
E
input
output
Y
1
Corporate Finance 2-10
© Professor Ho-Mou Wu
Corporate Investment Decision Making ‑
C
o
n
s
u
m
p
t
i
o
n

a
t

t
+
1
Positive NPV projects shift the
shareholder’s opportunity set out,
which is unambiguously good.
All shareholders agree on their
preference for positive NPV
projects, whether they are
borrowers or lenders.
Corporate Finance 2-11
© Professor Ho-Mou Wu
( ) Investment Opportunities with Financial Markets Ⅲ
Financial markets present
saving/borrowing
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 Ⅱ
optimal investment plan yet.
C
0
B
A
D
E
C
1
slope = -(1+r)
PV(D)
Corporate Finance 2-12
© Professor Ho-Mou Wu
Project Valuation in a Riskless World
C
0
A’
D
E
slope = -(1+r)
PV(Y)
C
1
B’
Y
*
Y
1
Y
0
Y* is the optimal
investment plan, which is
the one that maximizes
NPV(Y) =PV(Y) -E or
PV(Y).
Perfect capital market
(borrowing rate =lending
rate) is assumed.
Corporate Finance 2-13
© Professor Ho-Mou Wu
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 rule—undertake positive
NPV projects and reject negative NPV projects.
Corporate Finance 2-14
© Professor Ho-Mou Wu
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.
E )
r 1
Y
Y (
r 1
Y
1
0
1
input
) Y E (
0

+
+ ·
+
+ − −
PV =
NPV = =
 +
+
+
+
+
+
3
3
2
2 1
) 1 ( ) 1 ( 1 r
CF
r
CF
r
CF
⋅ ⋅ ⋅ +
+
+
+
+
+
+ −
3
3
2
2 1
0
) 1 ( ) 1 ( 1 r
CF
r
CF
r
CF
CF
PV CF + −
0
Corporate Finance 2-15
© Professor Ho-Mou Wu
Fisher’s 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.
Corporate Finance 2-16
© Professor Ho-Mou Wu
Why do we use NPV or PV as investment criterion
Example 3. A project which requires $650m investment will have
payoffs $300m and $400m in the next two years. Is it a
good investment project when r

6%?
Example 4. Consider a two-period world with an interest rate of
25%. Suppose you have a fund of $100m and can choose
one from the following three projects. What is not
invested will be consumed. Which is the best project?
Investment
Payoffs
next period
1 25m 30m
2 50m 100m
3 100m 160m

Corporate Finance 2-17
© Professor Ho-Mou Wu
NPV as Investment Criterion
Example 3(continued):

NPV





Example 4(continued):
Y
0
Y
1
PV(Y)
NPV

PV

E

-CF
0+

1 75 30
75

30/1.25

99
-1 =
-25

30/1.25
2 50 100
50

100/1.25

130*
30*

-50

100/1.25
3 0 160 0

160/1.25

128 28

-100

160/1.25


r 1
CF
1
+
06 . 1
400
06 . 1
300
650 + + −
0 11 356 283 650 < − · + + −
Corporate Finance 2-18
© Professor Ho-Mou Wu
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%?
0 1 2 3 4 5
$20,000 PV
5
) 15 . 1 (
000 , 20 $
53 . 943 , 9 $ ·
Corporate Finance 2-19
© Professor Ho-Mou Wu
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?
T
r CF FV ) 1 (
0
+ × ·
T
) 10 . 1 ( 000 , 5 $ 000 , 10 $ × ·
2
000 , 5 $
000 , 10 $
) 10 . 1 ( · ·
T
2 ln ) 10 . 1 ln( ·
T
years 27 . 7
0953 . 0
6931 . 0
) 10 . 1 ln(
2 ln
· · · T
Corporate Finance 2-20
© Professor Ho-Mou Wu
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 child’s education?
What Rate Is Enough?
T
r CF FV ) 1 (
0
+ × ·
12
) 1 ( 000 , 5 $ 000 , 50 $ r + × ·
10
000 , 5 $
000 , 50 $
) 1 (
12
· · + r
12 1
10 ) 1 ( · + r
2115 . 1 2115 . 1 1 10
12 1
· − · − · r
Corporate Finance 2-21
© Professor Ho-Mou Wu
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.
Corporate Finance 2-22
© Professor Ho-Mou Wu
Perpetuity
A constant stream of cash flows that lasts forever.
0

1
C
2
C
3
C
The formula for the present value of a perpetuity is:
 +
+
+
+
+
+
·
3 2
) 1 ( ) 1 ( ) 1 ( r
C
r
C
r
C
PV
r
C
PV ·
Corporate Finance 2-23
© Professor Ho-Mou Wu
Growing Perpetuity
A growing stream of cash flows that lasts forever.
0

1
C
2
C×(1+g)
3
C ×(1+g)
2
The formula for the present value of a growing perpetuity is:
 +
+
+ ×
+
+
+ ×
+
+
·
3
2
2
) 1 (
) 1 (
) 1 (
) 1 (
) 1 ( r
g C
r
g C
r
C
PV
g r
C
PV

·
Corporate Finance 2-24
© Professor Ho-Mou Wu
Annuity
A constant stream of cash flows with a fixed maturity.
0 1
C
2
C
3
C
The formula for the present value of an annuity is:
T
r
C
r
C
r
C
r
C
PV
) 1 ( ) 1 ( ) 1 ( ) 1 (
3 2
+
+
+
+
+
+
+
· 
]
]
]

+
− ·
T
r r
C
PV
) 1 (
1
1
T
C

Corporate Finance 2-25
© Professor Ho-Mou Wu
Growing Annuity
A growing stream of cash flows with a fixed maturity.
0 1
C
The formula for the present value of a growing annuity:
T
T
r
g C
r
g C
r
C
PV
) 1 (
) 1 (
) 1 (
) 1 (
) 1 (
1
2
+
+ ×
+ +
+
+ ×
+
+
·


]
]
]
]

,
`

.
|
+
+


·
T
r
g
g r
C
PV
) 1 (
1
1

2
C×(1+g)
3
C ×(1+g)
2
T
C×(1+g)
T-1
Corporate Finance 2-26
© Professor Ho-Mou Wu
What Is a Firm Worth?

Conceptually, a firm should be worth the present
value of the firm’s cash flows.

The tricky part is determining the size, timing and
“risk” of those cash flows : we will probe further in
later class..

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