Present Value and the

Opportunity Cost of
Capital
COR P OR ATE F I N AN CE
DR . A MNISUHA IL AH A BA R A HA N
JA N UA RY, 2 0 2 0.
Introduction
-Companies and individuals make investments. Example: college education
-requires comparison of cash payments at different rates.
-is future CF sufficient?
-Must understand value of dollars today and dollars in the future.
- to workout the value of a series of cash payments.
Future Values & Present Values
-Money invested to get interest.
-Example: $100 interest rate r= 7%
Thus,
$100 x (1+r)= $107------------ FV of 1st year
-What happens if you leave it until the 2nd year?
-$107 x(1.07)= $114.49
-* interest given at $100 initial and $7 interest gained in 1st year. This is
compound interest.
- The higher the interest rate, the higher your savings.
How to calculate present values
Discount Factor DF= PV of $1

Discount factor can be used to compute the present value for any cash flow.
Present Values
Present Values
Example:
You just bought a new computer for $3000. The payment terms are 2 years same as cash. If you
earn 8% on your money, how much money should you set aside today in order to make the
payment when due in two years?

PV
Calculating PV
How much do you need to invest today to produce $114.49 at the end of 2nd
year?
PV= $114.49 = $100
(1.07)2

𝑟= discount rate
PV is the discounted value of the cash flow, 𝐶 𝑡
Discount Factor of example above.

1
DF2= = 0.8734
(1.07)2

Present value= DF2 x C2= 0.8734 x $114.49

= $100

* The longer you wait for your money the lower the present value.
Present Values
Given two dollars, one received a year from now and the other two years from now, the value of
each is commonly called discount factor.
Assume r1= 20% and r2=7%
Present value
PV can be added together to evaluate multiple cash flows
Valuing an Investment Opportunity
Suppose you own a small company contemplating construction of a suburban office block. The
cost of buying land and constructing the building is $700,000. Your company has cash to finance
construction. Your real estate adviser forecasts a shortage of office space and predicts that you
will be able to sell next year for $800,000. *Assuming $800,000 is a sure thing.

1st. Calculate ROR of the one period project. Expected profit

Required investment
=$800,000- $700,00 = $100,000 = 0.143 = 14.3%
$700,000 $700,000
What is the opportunity cost of capital?
Assume that they can earn a profit of 7 % profit by investing for a year in safe
assets (debt securities.
-Thus 7% is the opportunity cost of capital. Shareholders would say yes to the
investment project because of the safe return of 14% versus safe return of only
7% in financial markets.

- Yes to the project! But how much is it worth?

In this case the project produces a cash flow at the end of 1 year.

Discount the cash flow by the opportunity cost of capital to find the present value.

PV= 𝐶1 = $800,000 = $747,664

1+r 1.07
Suppose that as soon as you bought the land and paid for construction, you decide to sell the
project. How much could you sell for it?
- $747,664 is the feasible price.
* the PV of the property is also the market price.
Net Present Value
Office building worth $747,664 today. You invested $700,000 so NPV is:

NPV= PV- Investment= $747,664- $700,000= $47,664.

* worth more than it costs.
* Always helpful to draw a timeline if cash flows occur at different points of
time.
Risk and Present Value
- the assumption on our example was unrealistic. Profitability could not be made
certain.
-if your CF are uncertain, then your NPV is wrong because investors can achieve
those cash flows with certainty by buying government securities. They would
not buy the building.
-Basic principle: A safe dollar is worth more than a risky dollar.
-They will only invest if they see the prospect of higher returns.
-concepts of PV and opportunity cost of capital still apply for risky investments.
-Risk depends on nature of investments.
Risk and Present Value
Higher risk projects require higher rate of return.
Higher required rate of return cause lower PVs.
Risk and Present Value
Example
Suppose you believe that the project is a risky investment in the stock market and stocks are
expected to provide 12% return.
-The opportunity cost of capital for your project:12%
-what you are giving up by investing in the office and not investing in equally risky securities.
Recomputing NPV with r= 0.12
PV= 800,000 = $ 714, 286
1.12
NPV= PV- $700,000= $14,286
•The project still makes a contribution to value but the increase in wealth is smaller than the first
calculation.
•The value of the building depends on the timing cash flows and the risk.
Present Values and Rates of Return
Decision rule: venture of the building is worth it because rate of return exceeds
the opportunity cost of capital.
ROR= Profit = 800,000-700,000 =14.3%
Investment 700,000
*cost of capital: return foregone by not investing in financial markets.
RULES:
NPV rule- Accept investments that have positive net present value
ROR rule- Accept investments that offer ROR in excess of their opportunity costs
of capital.
Calculating PV with Multiple CF
PV= 𝐶1 + 𝐶2 + 𝐶3 + …… + 𝐶𝑡
(1+r) (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)𝑡

This is called the discounted cash flow or DCF formula.

Example
Your real estate adviser suggests that you rent out the building for two years at
$30,000 a year. He predicted that at the end of that time you will be able to sell
the building for $840,000.
- There are now two future cash flows. C1= $30,000 C2= ($30,000 + $840,000)=
$870,000.
PV= 30,000 + 870,000 = 26,786 + 693,559 = $720,344
1.12 (1.12)2
NPV= $720, 344- $700,000= $20, 344.
How to Value Perpetuities
Return of Perpetuity = Cash Flow
PV
r= C
PV
Example on Perpetuity
It is 2030. You are now a billionaire. You want to help eradicate a disease by
endowing a foundation to combat the disease. You aim to provide $1 billion a
year in perpetuity, starting next year. If the interest rate is 10%, you need to have
a check today for;

PV of Perpetuity: C = $1 billion = $10 billion

r 0.1
How to Value Annuities
Annuity: An asset that pays a fixed sum each year for a specified number of
years.
To know annuity: calculate value of each CF and find total.
1 1
Present value of t-year annuity = C −
𝑟 𝑟 (1+𝑟)𝑡

Also known as t-year annuity factor.

Example:
Suppose that Tony Autos offers an easy payment scheme on a new Toyota of
$5000 per year, paid at the end of each of the next five years, with no cash
down. What is the car really costing you? 7% interest rate.
1 1
PV= $5000 -
0.07 0.07 (1+1.07)5

= $5000 x 4,100 = $20,501

Example
In august 2019, five individuals pooled their money to buy a lottery ticket. They won 365 million
through the lottery. The individuals were well aware that the prize was not even close to 365
million. The prize was to be paid in 30 equal annual installments of $12.167 million each.
Assuming that the first payment occurred at end of one year, what was the present value of the
prize? The interest rate at the time was 6%.

PV= 12.167 x 30 year annuity factor

1 1
= 12.167 x −
0.06 0.06(1.06)30

= 12.167 x 13.765
=167.5 million
Valuing Annuities Due
-level of payments starting immediately is called annuity due.
Example:
Suppose that you take out a four year loan of $1000. The bank requires you to repay the loan evenly over
four years.
PV= loan payment x 4-year annuity factor= 1000
Annual loan payment= 1000/ 4 year annuity factor
Suppose the interest rate is 10%
1 1
Then 4 year annuity factor= − = 3.17
0.10 0.10(1.10)4
1000
Annual loan payment = = $315.47
3.17
*FV of annuity at end of year t= present value x 1 + 𝑟 𝑡
Growing Perpetuities
-stream of cash flows that grows at a constant rate.
Example on billionaire wanting to fund an endowment for battling diseases. Lets say that the growth
in salaries and other costs is about 4% per year starting in year 1.
Thus, instead of providing 1 billion a year in perpetuity, you must provide 1 billion in year 1, 1.04
billion in year 2 and so on.
𝐶1
Present value of growing perpetuity=
𝑟−𝑔
Therefore, if you were to provide stream of income that keeps pace with the growth rate in costs
𝐶1 1 𝑏𝑖𝑙𝑙𝑖𝑜𝑛
PV= = = 16.667 billion ( amount today)
𝑟−𝑔 0.10−0.04
Growing Annuities
Example:
You are contemplating a membership in an exclusive club. The annual membership fee for the coming
year is $5000 but you can make a single payment today of $12,750, which will provide you with
membership fees for the next three years. Which is a better deal? Suppose that the annual fee is
payable at the end of each year and expected to increase by 6% per annum. The discount rate is 10%.
1 (1+𝑔)𝑡
PV= C x 1−
𝑟−𝑔 (1+𝑟)𝑡
1 (1+0.06)3
PV= 5000 x 0.1−0.06
1− (1+0.1)3

= 5000 x 2.629
= $13,147
Pay now or installment better?
How interest is paid and quoted
-semi-annually or annually
-Example: bank offers a car loan APR 12% interest paid monthly. 1% per month
-the effective annual rate on your loan is 1.0112 -1 = 0.1268 or 12.68%
-differentiate between quoted annual interest rate and effective annual rate.
-when interest rate is paid more frequently, the effective interest rate is higher than the quoted
rate.