Chapter 1: Present-value calculations and the valuation of physical investment projects

Chapter 1: Present-value calculations

and the valuation of physical investment
projects

Aim of the chapter

The aim of this chapter is to introduce the Fisher separation theorem,
which is the basis for using the net present value (NPV) for project
evaluation purposes. With this aim in mind, we discuss the optimality
of the NPV criterion and compare this criterion with alternative project
evaluation criteria.

Learning objectives
At the end of this chapter, and having completed the essential reading and
activities, you should be able to:
• analyse optimal physical and financial investment in perfect capital
markets and derive the Fisher separation result
• justify the use of the NPV rules via Fisher separation
• compute present and future values of cash-flow streams and appraise
projects using the NPV rule
• evaluate the NPV rule in relation to other commonly used evaluation
criteria
• value stocks and bonds via NPV.

Essential reading
Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,
Mass.; London: McGraw-Hill, 2002) Chapter 10.

Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston,
Mass.; London: McGraw-Hill, 2008) Chapters 2, 3, 5, 6 and 7.
Copeland, T. and J. Weston Financial Theory and Corporate Policy. (Reading,
Mass.; Wokingham: Addison-Wesley, 2005) Chapters 1 and 2.
Roll, R. ‘A Critique of the Asset Pricing Theory’s Texts. Part 1: On Past and
Potential Testability of the Theory’, Journal of Financial Economics 4(2)
1977, pp.129–76.

Overview
In this chapter we present the basics of the present-value methodology
for the valuation of investment projects. The chapter develops the net
present-value (NPV) technique before presenting a comparison with the
other project evaluation criteria that are common in practice. We will also
discuss the optimality of NPV and give a number of extensive examples.

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92 Corporate finance

Introduction
Let us begin by defining how we are going to think about a firm in this
chapter. For the purposes of this chapter, we will consider a firm to be a
package of investment projects. The key question, therefore, is how do the
firm’s shareholders or managers decide on which investment projects to
undertake and which to discard? Developing the tools that should be used
for project evaluation is the emphasis of this chapter.
It may seem, at this point, that our definition of the firm is rather limited.
It is clear that, in only examining the investment operations of the firm,
we are ignoring a number of potentially important firm characteristics.
In particular, we have made no reference to the financial structure or
decisions of the firm (i.e. its capital structure, borrowing or lending
activities, or dividend policy). The first part of this chapter presents what
is known as the Fisher separation theorem. What follows is a statement
of the theorem. This theorem allows us to say the following: under
certain conditions (which will be presented in the following section), the
shareholders can delegate to the management the task of choosing which
projects to undertake (i.e. determining the optimal package of investment
projects), whereas they themselves determine the optimal financial
decisions. Hence, the theory implies that the investment and financing
choices can be completely disconnected from each other and justifies our
limited definition of the firm for the time being.

Fisher separation and optimal decision-making

Consider the following scenario. A firm exists for two periods
(imaginatively named period 0 and period 1). The firm has current funds
of m and, without any investment, will receive no money in period 1.
Investments can be of two forms. The firm can invest in a number of
physical investment projects, each of which costs a certain amount of cash
in period 0 and delivers a known return in period 1. The second type of
investment is financial in nature and permits the firm to borrow or lend
unlimited amounts at rate of interest r. Finally the firm is assumed to have
a standard utility function in its period 0 and period 1 consumption. (By
consumption we mean the use of any funds available to the firm net of any
costs of investment.)
Let us first examine the set of physical investments available. The firm
will logically rank these investments in terms of their return, and this will
yield a production opportunity frontier that looks as given in Figure 1.1
(and is labelled POF). This curve represents one manner in which the firm
can transform its current funds into future income, where c0 is period 0
consumption, and c1 is period 1 consumption. Using the assumed utility
function for the firm, we can also plot an indifference map on the same
diagram to find the optimal physical investment plan of a given firm. The
optimal investment policies of two different firms are shown in Figure 1.1.
It is clear from Figure 1.1 that the specifics of the utility function of
the firm will impact upon the firm’s physical investment policy. The
implication of this is that the shareholders of a firm (i.e. those whose
utility function matters in forming optimal investment policy) must dictate
to the managers of the firm the point to which it invests. However, until
now we have ignored the fact that the firm has an alternative method for
investment (i.e. using the capital market).

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 Chapter 1: Present-value calculations and the valuation of physical investment projects

Figure 1.1
The financial investment allows firms to borrow or lend unlimited
amounts at rate r. Assuming that the firm undertakes no physical
investment, we can define the firm’s consumption opportunities quite
easily. Assume the firm neither borrows nor lends. This implies that
current consumption (c0) must be identically m, whereas period 1
consumption (c1) is zero. Alternatively the firm could lend all of its funds.
This leads to c0 being zero and c1 = (1 + r) m. The relationship between
period 0 and period 1 consumption is therefore given as below:
c1 = (1 + r)(m – c0 ). (1.1)
This implies that the curve which represents capital market investments is
a straight line with slope –(1+r). This curve is labeled CML on Figure 1.2.
Again, we have on Figure 1.2 plotted the optimal financial investments for
two different sets of preferences (assuming that no physical investment is
undertaken).

Figure 1.2
Now we can proceed to analyse optimal decision-making when firms
invest in both financial and physical assets. Assume the firm is at the
beginning of period 0 and trying to decide on its investment plan. It is
clear that, to maximise firm value, the projects undertaken should be those

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92 Corporate finance

with the greatest return. Knowing that the return on financial investment
is always (1+r), the firm will first invest in all physical investment
projects with returns greater than (1+r ). These are those projects on the
production possibility frontier (PPF) between points m and I on Figure
1.3.1 Projects above I on the PPF have returns that are dominated by the 1
The absolute value of
return from financial investment. the slope of the PPF can
be equated with the
Hence the firm physically invests up to point I. Note that, at this point, return on physical
we have not mentioned the firm’s preferences over period 0 and period investment. For all points
1 consumption. Hence, the decision to physically invest to I will be taken below I on the PPF, this
by all firms regardless of the preferences of their owners. Preferences slope exceeds that of
the capital market line
come into play when we consider what financial investments should be
and hence defines the
undertaken. set of desirable physical
The firm’s physical investment policy takes it to point I, from where it can investment projects.

borrow or lend on the capital market. Borrowing will move the firm to
the south-east along a line starting at I and with slope –(1+r); lending will
take the firm north-west along a similarly sloped line. Two possible optima
are shown on Figure 1.3. The optimum at point X is that for a firm whose
owners prefer period 1 consumption relative to period 0 consumption (and
have hence lent on the capital market), whereas a firm locating at Y has
borrowed, as its owners prefer date 0 to date 1 consumption.
Figure 1.3 demonstrates the key insight of Fisher separation. All firms,
regardless of preferences, will have the same optimal physical investment
policy, investing to the point where the PPF and capital market line are
tangent. Preferences then dictate the firm’s borrowing or lending policy
and shift the optimum along the capital market line. The implication of
this is that, as it is physical investment that alters firm value, all agents
(i.e. regardless of preferences) agree on the physical investment policy that
will maximise firm value. More specifically, the shareholders of the firm
can delegate choice of investment policy to a manager whose preferences
may differ from their own, while controlling financial investment policy in
order to suit their preferences.

Figure 1.3

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 Chapter 1: Present-value calculations and the valuation of physical investment projects

Fisher separation and project evaluation

Fisher separation can also be used to justify a certain method of project
appraisal. Figure 1.3 shows a sub-optimal physical investment decision (I’)
and the capital market line that borrowing and lending from point I’ would
trace out. Clearly this capital market line always lies below that achieved
through the optimal physical investment policy. Hence, one could say that
optimal physical investment should maximise the horizontal intercept of
the capital market line on which the firm ends up. Let us, then, assume a
firm that decides to invest a dollar amount of I0. Given that the firm has
date 0 income of m and no date 1 income, aside from that accruing from
physical investment, the horizontal intercept of the capital market line
upon which the firm has located is:
∏(I0)
m – I0 +
1+ r
where Π(I0) is the date 1 income from the firm’s physical investment.
Maximising this is equivalent to the following maximisation problem:
∏(I0)
max – I0.
I0 1+ r

The prior objective is the net present-value rule for project appraisal. It
says that an optimal physical investment policy maximises the difference
between investment proceeds divided by one plus the interest rate and the
investment cost. Here, the term ‘optimal’ is being defined as that which leads
to maximisation of shareholder utility. We will discuss the NPV rule more
fully (and for cases involving more than one time period) later in this chapter.
The assumption of perfect capital markets is vital for our Fisher separation
results to hold. We have assumed that borrowing and lending occur at the
same rate and are unrestricted in amount and that there are no transaction
costs associated with the use of the capital market. However, in practical
situations, these conditions are unlikely to be met. A particular example is
given in Figure 1.4. Here we have assumed that the rate at which borrowing
occurs is greater than the rate of interest paid on lending (as the real world
would dictate). Figure 1.3 shows that there are now two points at which the
capital market lines and the production opportunities frontier are tangential.
This then implies that agents with different preferences will choose differing
physical investment decisions and, therefore, Fisher separation breaks down.

Figure 1.4

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92 Corporate finance

Agents with strong preferences for future consumption will physically

invest to point X and then financially invest to an optimum on the
capital market lending line (CML). Those with strong preferences for
current consumption physically invest to point Y and borrow (along
CML’). Finally, a set of agents may exist who value current and future
consumption similarly, and these will optimise by locating directly on the
PPF and not using the capital market at all. An example of an optimum of
this type is point Z on Figure 1.4.

The time value of money

In the preceding section we demonstrated the Fisher separation theorem
and the manner in which physical and financial investment decisions can
be disconnected. The major implication of this theorem is that the set of
desirable physical investment projects does not depend on the preferences
of individuals. In the following sections we shall focus on the way in
which individual physical investment projects should be evaluated. Our
key methodology for this will be the NPV rule, mentioned in the preceding
section. In the following sections we will show you how to apply the rule
to situations involving more than one period and with time-varying cash
flows.
To begin, let us consider a straightforward question. Is $1 received today
worth the same as $1 received in one year’s time? A naïve response to
this question would assert that $1 is $1 regardless of when it is received,
and hence the answer to the question would be yes. A more careful
consideration of the question brings the opposite response however. Let’s
assume I receive $1 now. If I also assume that there is a risk-free asset in
which I can invest my dollar (e.g. a bank account), then in one year’s time
I will receive $(1+r), assuming I invest. Here, r is the rate of return on the
safe investment. Hence $1 received today is worth $(1+r) in one year. The
answer to the question is therefore no. A dollar received today is worth
more than a dollar received in one year or at any time in the future.
The above argument characterises the time value of money. Funds are
more valuable the earlier they are received. In the previous paragraph we
illustrated this by calculating the future value of $1. We can similarly
illustrate the time value of money by using present values. Assume I
am to receive $1 in one year’s time and further assume that the borrowing
and lending rate is r. How much is this dollar worth in today’s terms?
To answer this second question, put yourself in the position of a bank.
Knowing that someone is certain to receive $1 in one year, what is the
maximum amount you would lend him or her now? If I, as a bank, were to
lend someone money for one year, at the end of the year I would require
repayment of the loan plus interest (at rate r). Hence if I loaned the
individual $x I would require a repayment of $x(1+r). This implies that the
maximum amount I should be willing to lend is implicitly defined by the
following equation:
$x(1 + r) = $1 (1.2)
such that:
1 .
x =$ (1.3)
1+ r
The value for x defined in equation 1.3 is the present value of $1
received in one year’s time. This quantity is also termed the discounted
value of the $1.

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 Chapter 1: Present-value calculations and the valuation of physical investment projects

You can see the present and future value concepts pictured in Figure 1.2.
If you recall, Figure 1.2 just plots the CML for a given level of initial funds
(m) assuming no funds are to be received in the future. The future value
of this amount of money is simply the vertical intercept of the CML (i.e.
m(1+r)), and obviously the present value of m(1+r) is just m.
The present and future value concepts are straightforwardly extended
to cover more than one period. Assume an annual compound interest rate
of r. The present value of $100 to be received in k year’s time is:

PVK (100 ) =100 (1.4)

(1 + r) K
whereas the future value of $100 received today and evaluated k years
hence is:

FVk (100) = 100(1 + r)K. (1.5)

Activity
Below, there are a few applications of the present and future value concepts. You should
attempt to verify that you can replicate the calculations given below.
Assume a compound borrowing and lending rate of 10 per cent annually.
a. The present value of $2,000 to be received in three years time is $1,502.63.
b. The present value of $500 to be received in five years time is $310.46.
c. The future value of $6,000 evaluated four years hence is $8,784.60.
d. The future value of $250 evaluated 10 years hence is $648.44.

The net present-value rule

In the previous section we demonstrated that the value of funds depends
critically on the time those funds are received. If received immediately,
cash is more valuable than if it is to be received in the future.
The net present-value rule was introduced in simple form in the section
on Fisher separation. In its more general form, it uses the discounting
techniques provided in the previous section in order to generate a
method of evaluating investment projects. Consider a hypothetical
physical investment project, which has an immediate cost of I. The project
generates cash flows to the firm in each of the next k years, equal to Ck.
In words, all that the NPV rule does is to compute the present value of all
receipts or payments. This allows direct comparisons of monetary values,
as all are evaluated at the same point in time. The NPV of the project is
then just the sum of the present values of receipts, less the sum of the
present values of the payments.
Using the notation given above and again assuming a rate of return of r,
the NPV can be written as:
k Ci
NPV = ∑ − I . (1.6)
(
i =1 1 + r
)i
Note that the cash flows to the project can be positive and negative,
implying that the notation employed is flexible enough to embody both
cash inflows and outflows after initiation.

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92 Corporate finance

Once we have calculated the NPV, what should we do? Clearly, if the NPV
is positive, it implies that the present value of receipts exceeds the present
value of payments. Hence, the project generates revenues that outweigh its
costs and should therefore be accepted. If the NPV is negative the project
should be rejected, and if it is zero the firm will be indifferent between
accepting and rejecting the project.
This gives a very straightforward method for project evaluation. Compute
the NPV of the project (which is a simple calculation), and if it is greater
than zero, the project is acceptable.

Example
Consider a manufacturing firm, which is contemplating the purchase of a new piece of
plant. The rate of interest relevant to the firm is 10 per cent. The purchase price is £1,000.
If purchased, the machine will last for three years and in each year generate extra revenue
equivalent to £750. The resale value of the machine at the end of its lifetime is zero. The
NPV of this project is:

NPV = 750 + 750 + 750 – 1000 = 865.14.

(1.1)3 (1.1)2 (1.1)1

As the NPV of the project exceeds zero, it should be accepted.

In order to familiarise yourself with NPV calculations, attempt the following

activities by calculating the NPV of each project and assessing its desirability.

Activity
Assume an interest rate of 5 per cent. Compute the NPV of each of the following projects,
and state whether each project should be accepted or not.
•• Project A has an immediate cost of $5,000, generates $1,000 for each of the next
six years and zero thereafter.
•• Project B costs £1,000 immediately, generates cash flows of £600 in year 1,
£300 in year 2 and £300 in year 3.
•• Project C costs ¥10,000 and generates ¥6,000 in year 1. Over the following years,
the cash flows decline by ¥2,000 each year, until the cash flow reaches zero.
•• Project D costs £1,500 immediately. In year 1 it generates £1,000. In year 2 there
is a further cost of £2,000. In years 3, 4 and 5 the project generates revenues of
£1,500 per annum.

Up to this point we have just considered single projects in isolation,

assuming that our funds were enough to cover the costs involved. What
happens, first of all, if the members of a set of projects are mutually
exclusive?2 The answer is simple. Pick the project that has the greatest NPV. 2
By this we mean that
Second, what should we do if we have limited funds? It may be the case taking on any one of the
set of projects precludes
that we are faced with a pool of projects, all of which have positive NPVs,
us from accepting any of
but we only have access to an amount of money that is less than the total the others.
investment cost of the entire project pool. Here we can rely on another
nice feature of the NPV technique. NPVs are additive across projects (i.e.
the NPV of taking on projects A and B is identical to the NPV of A plus the
NPV of B). The reason for this should be obvious from the manner in which
NPVs are calculated. Hence, in this scenario, we should calculate all project
combinations that are feasible (i.e. the total investment in these projects
can be financed with our current funds). Then calculate the NPV of each
combination by summing the NPVs of its constituents, and finally choose
the combination that yields the greatest total NPV.

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 Chapter 1: Present-value calculations and the valuation of physical investment projects

Finally, we should devote some time to discussion of the ‘interest rate’ we

have used to discount future cash flows. Until now we have just referred
to r as the rate at which one can borrow or lend funds. A more precise
definition of r is that r is the opportunity cost of capital. If we are
considering the use of the NPV rule within the context of a firm, we have
to recognise that the firm has several sources of capital, and the cost of
each of these should be taken into account when evaluating the firm’s
overall cost of capital. The firm can raise funds via equity issues and
debt issues, and it is likely that the costs of these two types of funds will
differ. Later on in this chapter and in those that follow, we will present
techniques by which the firm can compute the overall cost of capital for its
enterprise.

Other project appraisal techniques

The NPV methodology for project appraisal is by no means the only
technique used by firms to decide on their physical investment policy. It is
however the optimal technique for corporate management to use if they
wish to maximise expected shareholder wealth. This result is obvious from
our Fisher separation analysis. In this section we talk about a couple of
NPV’s competitors, the payback and internal rate of return (IRR)
rules, which are sometimes used in practice.

The payback rule

Payback is a particularly simple criterion for deciding on the desirability
of an investment project. The firm chooses a fixed payback period, for
example, three years. If a project generates enough cash in the first three
years of its existence to repay the initial investment outlay, then it is
desirable, and if it doesn’t generate enough cash to cover the outlay, it
should be rejected. Take the cash-flow stream given in the following table
as an example.
Year 0 1 2 3 4
Cash flow –1,000 250 250 250 500
Table 1.1
A firm that has chosen a payback period of three years and is faced with
the project shown in Table 1.1 will reject it as the cash flow in years 1 to
3 (750) doesn’t cover the initial outlay of 1,000. Note, however, that if the
firm used a payback period of four years, the project would be acceptable,
as the total cash flow to the project would be 1,250, which exceeds the
outlay. Hence, it’s clear that the crucial choice by management is of the
payback period.
We can also use the preceding example to illustrate the weaknesses of
payback. First, assume the firm has a payback period of three years. Then,
as previously mentioned, the project in Table 1.1 will not be accepted.
However, assume also that, instead of being 500, the project cash flow in
year 4 is 500,000. Clearly, one would want to revise one’s opinion on the
desirability of the project, but the payback rule still says you should reject
it. Payback is flawed, as a portion of the cash-flow stream (that realised
after the payback period is up) is always ignored in project evaluation.
The second weakness of payback should be obvious, given our earlier
discussion of NPV. Payback ignores the time value of money. Sticking with
the example in Table 1.1, assume a firm has a payback period of four years.
Then the project as given should be accepted (as total cash flow of 1,250
exceeds investment outlay of 1,000). But what’s the NPV of this project?

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92 Corporate finance

If we assume, for example, a required rate of return of 10 per cent, then

the NPV can be shown to be negative. (In fact the NPV is –36.78. As a
self-assessment activity, show that this is the case.) Hence application of
the payback rule tells us to accept a project that would decrease expected
shareholder wealth (as shown by application of the NPV rule). This flaw
could be eliminated by discounting project cash flows that accrue within
the payback period, giving a discounted payback rule, but such a
modification still wouldn’t solve the first problem we highlighted.

The internal rate of return criterion

The IRR rule can be viewed as a variant on the apparatus we used in the
NPV formulation. The IRR of a project is the rate of return that solves the
following equation:
k Ci
∑ I 0
i − =
(1.7)
i =1
(1 + r)
where Ci is the project cash flow in year i, and I is the initial (i.e. year 0)
investment outlay. Comparison of equation 1.7 with 1.6 shows that the
project IRR is the discount rate that would set the project NPV to zero.
Once the IRR has been calculated, the project is evaluated by comparing
the IRR to a predetermined required rate of return known as a hurdle
rate. If the IRR exceeds the hurdle rate, then the project is acceptable,
and if the IRR is less than the hurdle rate it should be rejected. A graphical
analysis of this is presented in Figure 1.5, which plots project NPV against
the rate of return used in NPV calculation. If r* is the hurdle rate used
in project evaluation, then the project represented by the curve on the
figure is acceptable as the IRR exceeds r*. Clearly, if r* is also the correct
required rate of return, which would be used in NPV calculations, then
application of the IRR and NPV rules to assessment of the project in Figure
1.5 gives identical results (as at rate r* the NPV exceeds zero).

Figure 1.5
Calculation of the IRR need not be straightforward. Rearranging equation
1.7 shows us that the IRR is a solution to a kth order polynomial in r.
In general, the solution must be found by some iterative process, for
example, a (progressively finer) grid search method. This also points to
a first weakness of the IRR approach; as the solution to a polynomial,
the IRR may not be unique. Several different rates of return might satisfy
equation 1.7; in this case, which one should be used as the IRR? Figure 1.6
gives a graphical example of this case.

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 Chapter 1: Present-value calculations and the valuation of physical investment projects

Figure 1.6
The graphical approach can also be used to illustrate another weakness
of the IRR rule. Consider a firm that is faced with a choice between two
mutually exclusive investment projects (A and B). The locus of NPV-rate of
return pairings for each of these projects is given on Figure 1.7.
The first thing to note from the figure is that the IRR of project A
exceeds that of B. Also, both IRRs exceed the hurdle rate, r*. Hence,
both projects are acceptable but, using the IRR rule, one would choose
project A as its IRR is greatest. However, if we assume the hurdle rate is
the true opportunity cost of capital (which should be employed in an NPV
calculation), then Figure 1.7 indicates that the NPV of project B exceeds
that of project A. Hence, in the evaluation of mutually exclusive projects,
use of the IRR rule may lead to choices that do not maximise expected
shareholder wealth.

Figure 1.7
The lesson of this section is therefore as follows. The most commonly
used alternative project evaluation criteria to the NPV rule can lead to
poor decisions being made under some circumstances. By contrast, NPV
performs well under all circumstances and thus should be employed.

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92 Corporate finance

Using present-value techniques to value stocks and

bonds
To end this chapter, we will discuss very briefly how to value common
stocks and bonds through the application of present-value techniques.

Stocks
Consider holding a common equity share from a given corporation. To
what does this equity share entitle the holder? Aside from issues such as
voting rights, the share simply delivers a stream of future dividends to
the holder. Assume that we are currently at time t, that the corporation is
infinitely long-lived (such that the stream of dividends goes on forever)
and that we denote the dividend to be paid at time t+i by Dt+i. Also
assume that dividends are paid annually. Denoting the required annual
rate of return on this equity share to be re, then a present value argument
would dictate that the share price (P) should be defined by the following
formula:
∞ D
P= ∑ (1 + rt+i) i . (1.8)
i =1 e

Note that in the above representation we have assumed that there is no

dividend paid at the current time (i.e. the summation does not start at
zero). In plain terms, what equation 1.8 says is that an equity share is
worth only the discounted stream of annual dividends that it delivers.
A simplification of the preceding formula is available when we assume that
the dividend paid grows at constant percentage rate g per annum. Then,
assuming that a dividend of D0 has just been paid, the future stream of
dividends will be D0(1+g), D0(1+g)2, D0(1+g)3 and so on. This type of cash-
flow stream is known as a perpetuity with growth, and its present
value can be calculated very simply.3 In this setting the price of the equity 3
See Appendix 1.
share is:
D ( 1 + g)
P = 0 . (1.9)
re – g

This is the Gordon growth model of equity valuation. As is obvious

from the preceding discussion, it is only valid if you can assert that
dividends grow at a constant rate.
Note also that if you have the share price, dividend just paid and an
estimate of dividend growth, you can rearrange equation 1.9 to give the
required rate of return on the stock – that is:

re = D0 ( 1 + ) + g.
g
(1.10)
P
The first term in 1.10 is the expected dividend yield on the stock, and the
second is expected dividend growth. Hence, with empirical estimates of
the previous two quantities, we can easily calculate the required rate of
return on any equity share.

Activity
Attempt the following questions:
1. An investor is considering buying a certain equity share. The stock has just paid
a dividend of £0.50, and both the investor and the market expect the future
dividend to be precisely at this level forever. The required rate of return on
similar equities is 8 per cent. What price should the investor be prepared to pay
for a single equity share?

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 Chapter 1: Present-value calculations and the valuation of physical investment projects

2. A stock has just paid a dividend of $0.25. Dividends are expected to grow at
a constant annual rate of 5 per cent. The required rate of return on the share
is 10 per cent. Calculate the price of the stock.
3. A single share of XYZ Corporation is priced at $25. Dividends are expected
to grow at a rate of 8 per cent, and the dividend just paid was $0.50. What is
the required rate of return on the stock?

Bonds
In principle, bonds are just as easy to value.
• A discount or zero coupon bond is an instrument that promises
to pay the bearer a given sum (known as the principal) at the end of
the instrument’s lifetime. For example, a simple five-year discount bond
might pay the bearer $1,000 after five years have elapsed.
• Slightly more complex instruments are coupon bonds. These not
only repay the principal at the end of the term but in the interim entitle
the bearer to coupon payments that are a specified percentage of
the principal. Assuming annual coupon payments, a three-year bond
with principal of £100 and coupon rate of 8 per cent will give annual
payments of £8, £8 and £108 in years 1, 2 and 3.
In more general terms, assuming the coupon rate is c, the principal is P
and the required annual rate of return on this type of bond is rb, the price
of the bond can be written as:4 4
In our notation a
coupon rate of 12
cP + p ( 1 + c) .
k –1
PB = ∑ (1 + rb ) i (1 + rb ) k
(1.11) per cent, for example,
i =1 implies that c = 0.12;
Note that it is straightforward to value discount bonds in this framework the discount rate used
here, rb, is called the
by setting c to zero.
yield to maturity of the
bond.
Activity
Using the previous formula, value a seven-year bond with principal $1,000, annual
coupon rate of 5 per cent and required annual rate of return of 12 per cent.
(Hint: the use of a set of annuity tables might help.)

A reminder of your learning outcomes

Having completed this chapter, and the essential reading and activities,
you should be able to:
• analyse optimal physical and financial investment in perfect capital
markets and derive the Fisher separation result
• justify the use of the NPV rules via Fisher separation
• compute present and future values of cash-flow streams and appraise
projects using the NPV rule
• evaluate the NPV rule in relation to other commonly used evaluation
criteria
• value stocks and bonds via NPV.

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92 Corporate finance

Key terms
capital market line (CML)
consumption
Fisher separation theorem
Gordon growth model
indifference curve
internal rate of return (IRR) criterion
investment policy
net present value rule
payback rule
production opportunity frontier (POF)
production possibility frontier (PPF)
time value of money
utility function

Sample examination questions

1. The Toyundai Motor Company has the opportunity to invest in new
production line equipment, which would have a working lifetime of 10
years. The new equipment would generate the following increases in
Toyundai’s net cash flows.
In the first year of usage the new plant would decrease costs by
$200,000. For the following 6 years the cost saving would fall at a rate
of 5 per cent per annum. In the remaining years of the equipment’s
lifetime, the annual cost saving would be $140,000. Assuming that the
cost of the equipment is $1,000,000 and that Toyundai’s cost of capital
is 10 per cent, calculate the NPV of the project. Should Toyundai take
on the investment? (15%)
2. Describe two methods of project evaluation other than NPV. Discuss the
weaknesses of these methods when compared to NPV. (10%)

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