CHAPTER 2

Present Values, the Objectives of

the

Firm, and Corporate Governance

31

ioneerillg works on the net present value rule are; lFisher, The Theory of Interest (New York: Augustus M. Kelley, 1965). Reprinted from the

J. Hirshteifer, "On

1930 edi lion.

FURTHER READING

the Theory of Optimal Investment Decision," Journal of Political Economy

66 (August 1958), pp. 329-352.

Ifyoll would like to dig deeper into recent controversies about management incentives and corporate gaver/timer, we sttggest: J. Brickley, C. W. Smith, [r., and J. Zimmerman, "Ethics, Incentives and Organizational Design," Journal of Applied Corporate Finance 7 (Summer 1994), pp. 8-19. B. HQlmstrom and S. N. Kaplan, "The State of U.S. Corporate Governance: What's Right and Wh<lt's Wrong?" Journal of Applied Corporate Finance 15 (Spring 2003), pp. 8-20. JOIII'natof Applied Corporate Finance 17 (Fail 2005), a special issue all. executive pay and corporate governance. O. H. Chew, Jr., and S. L. Gillan, Corporate Governance at the Crossroads: A Book of Readings (New York: McGraw-Hill, 2005).
.i 1. Wb.at is the difference between a discount rate and a discount factor? (page 15) 2. How can risk be incorporated into PVs and Nf'Vs? (page 16) 3. Write down the formulas for an investment's NPV and rate of return. Prove that NPV is positive only if the rate of return exceeds the opportunity cost of capital. (page 17)

CONCEPT REVIEW QUESTIONS

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1. Cois the initial cash flow on an investment, C1 is the cash flow at the end of one year, and r is the discount rate. a. Is Co usually positive or negative?
b. \>\/hatis the formula for the present value of the investment?

QUIZ

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c. What is the formula for the net present value? d. The discount rate equals the opportunity

cost of capital. Why?

e. If the investment is risk-free, what is the appropriate measure of 1'7

2. If the present value of $150 paid at the end of one year is $130, what is the one-year discount factor? What is the discount rate? 3. Calculate the one-year discount factor DFI for discount rates of (a) 10%, (b) 20%, and
(c) 30%. 4. A merchant pays $100,000 for a load of grain and is certain that it can be resold at the end of one year for $132,000.

a. What is the return on this investment?
b. If this return is lower than the rate of interest, does the investment have a positive

or a negative NPV?
c. If the rate of interest is 10%, what is the PV of the investment? d. What is the NPV?

offers to purchase the land for $58. Would you construct the motel? Why or why not? 11.32 PART ONE Value 5. Help balance shareholders' checkbooks. we analyzed the possible construction of an office building on a plot of land appraised at $50.D 8. h. Suppose the interest rate is 20%. Should you accept E.000.000 after one year.000? Would they invest in the office building? Would they borrow or lend? How much and when would each consume? 7.000 -2. Calculate the NPV and rate of return for each of the following investments.000 +9. Why would one expect managers to act in shareholders' interests? Give some reasons. Coli will pay. $20. Modify the firm's investment plan to help shareholders achieve a particular time pattern of consumption. The land and motel should be worth $1.000 Cash Flow in Year 1.000. Coli is sure to pay the second $38.S. For example.000 next year.2. Make shareholders as wealthy as possible by investing in real assets with positive NPVs. You observe that other investors demand a 10% return on their loans to E. Coli's offer? . Suppose you are not sure E. Suppose E. We can imagine the financial manager doing several things on behalf of the firm's stockholders. c. How in principle would you find the opportunity cost of capital for a risk-free asset? For a risky asset? 6. For an additional $800. Which one? Why? :. the manager might: a.000 2 3 4 a. What is the net present value of afinn's investment in a U. d. Therefore you can take only one. Coli will not be able to pay.000 at a discount rate of 12%. A parcel of land costs $500. C1 +18. But in well-functioning capital markets.c .000 paid immediately and $38. Choose high. Define the opportunity cost of capital. Suppose each investment would require use of the same parcel of land. Treasury security yielding 5% and maturing in one year? (Hint: What is the opportunity cost of capital? Ignore taxes. Which one? (Hint: What is the firm's objective: to earn a high rate of return or to increase firm value?) 12. Should you take its offer or start on the office building? Explain.) 10. shareholders will vote for only one of these goals. The opportunity cost of capital is 20% for all four investments. . Assume that the other investors have correctly assessed the risks that E. Look back to the numerical example graphed in Figure 2.500.or low-risk assets to match shareholders' risk preferences.000. government securities maturing in one year yield 5%. a firm of genetic engineers. a. Assume E. Investment 1 .000 -5. Co -10. Coli.000 you can build a motel on the property. U. h.000 +5. Which investment is most valuable? b. What would the ant (A) and grasshopper (G) do if they both start with $185. In Section 2.000 installment.1. Suppose that common stocks with the same risk as this investment offer a 10% expected return.700 +4.s. We concluded that this investment had a positive NPV of $5.000 -5.c E l Initial Cash Flow. Coli Associates. e fa E S tJ PRACTICE QUESTIONS 9.

Tilkeanother look at investment opportunity (d) in Practice Question 13. Which 01 these investments have positive NPVs? Which would you advise Norman to take? Show that your answers to Practice Question 13 are consistent with the rate of return rule for investment decisions. Investment in local real estate. 16.0 to Norman's nephew Gerald. invests $1 million in real estate opportunity (d) and puts the rest of his money in opportunity (c). Ms. What is the expected cash flow? Assume the three outcomes for the economy are equally likely.000 at 10% risk-free. Liu. The interest rate is 8%.000 personal loan at 8%. Unfortunately the net cash flow from selling the tanker load will be very sensitive to the growth rate of the world economy: Slump $8 million Nonnal $12 million Boom $1. How should he invest a.6 million a. d. to fall by more or less than the amount of any fines and settlement payments? Explain. and how much can he consume in each period? c. Suppose a bank offers Norman a $600. a. who has for years aspired to open a big Cajun re5taurant in Duluth. Espinoza is retired and depends on her investments for her income. Suppose Casper is given an opportunity to invest up to $200. (Norman is a 101rrg"time customer of the bank and has an excellent credit history.rrymander h~s just received a $1 million bequest. This investment's payoff is many years away.1. What is the expected rate of return on the investment in the project? c.. 15. Explain why its investment also makes sense for Ms. Casper Milktoast has $200. which Norman judges is about as risky as the stock market. The opportunity at hand would cost $1 million and is forecasted to be worth $1. but asks for a $1 million loan from Norman at 9%.000 available to support consumption in periods 0 (now) and 1 (next year). ~at should he do.000 at 10%. and how much can he consume in each period? b.ent in one-year U'S. Espinoza. LLC. would you expect its value 14.CHAPTER 2 Present Values. If a financial institution is caught up in a financial scandal. The interest rate stays at 8%. How much should he invest. c. For an outlay of $8 million you can purchase a tanker load of bucolic acid delivered in Rotterdam one year hence. b. b. One share of stock Z is selling for $10. A 10. What is the NPV of the opportunity in (b)? 18. and Corporate Governance 33 it? There are four immedIate alternatives. Both are stockholders in Scaled Composites. the stock market. government securities yielding 5°/". Mr. 17. He wants to consume exactly the same amount in each period. The stock has the following payoffs after one year: . which is building SpaceShipOne to take commercial passengers into space. Gerald had arranged a one-year bank loan for $900. Investn1. The expected rate of return is 12%. the Objectives of the Firm. Is this a smart move? Explain. 19. Nonnan Ge. i million after one year. Answer this question by drawing graphs like Figure 2. Investment in the stock market. Liu is a young executive who wants to save for the future. Assume it has a positive NPV for Mr.) Suppose Norman borrows the money. There is no risk.

Y. X. How much will they add to the total market value of your company's shares? .65 40 10 $80 40 8 $110 44 12 $140 48 16 :> III a. Y. Band C. Your company has identified two more projects. What are the NPVs of projects Band C? e. and boom.34 PART ONE Value Slump Normal Boom $8 $12 $16 Calculate the expected rate of return offered by stock Z. CHALLENGE QUESTION 20.. What are the opportunity costs of capital for projects Band C? (Hint. What are the expected cash inflows of projects Band C? b. are in millions: Slump B C Normal Boom $4 5 $6 5. d.and Z: Payoff at Year 1 Current Price per Share X Slump Normal Boom .5 $8 6 You have identified the possible payoffs to investors in three stocks. Each will require a $5 million outlay immediately. In real life the future health of the economy cannot be reduced to three equally probable states like slump. :J IU $95. X.. Calculate the percentage differences. <- y Z '" . The possible payoffs at year 1. and Z? c. But we'll keep that simplification for one more example. Suppose Band Care launched and $5 million are invested in each.and Z_Match up to the percentage differences in B's and C's payoffs. Y.) d. Is the project a good investment? Explain why. What are the expected rates of return offered by stocks. Explain why this is the opportunity cost of capital for your bucolic acid project. slump versus normal and boom versus normal. normal. for stocks X.. Calculate the project's NPv.

An investment costs $1. $137 in year 2. The second idea is that arbitrage opportunities or money machines are rare and soon vanish. the dividends are expected to increase indefinitely at 4% per year.548 and pays $138 in perpetuity. CONCEPT REVIEW QUESTIONS 1.54 PARTONE Value formula for the present value of A + B is not the same as your formula for the present value of A plus the present value of B. A common stock will pay a cash dividend of $4 next year. how much will you have accumulated by the time that you retire in 30 years? Now log in to the Quicken site and find a nice savings calculator.507 worth in six years if invested at 12%? 2. go back and check your calculations. Use this to check your answer.quicken. If the cost of capital is 9%. you have made a mistake.com and www. what is the project's PV? 5. Can the two-period discount rate (T. If you earn a return of 12% a year (1% a month). Two good examples are www.) 1. what is the NPV? 7.) ever be smaller than the one-period rate (page 38) (Tl)? QUIZ 1. What is your total monthly payment? How much of the first month's payment goes to reduce the size of the loan? How much of the payment after two years goes to reduce the amount of the loan? You can check your answers by logging in to the personal finance page of www. If you think you have found one. what is the PV of $374 paid in year 9? 4. what is the discount factor? 3. 2. If you invest $100 at an interest rate of 15%. and $797 in year 3. the six-year discount factor is .com and using the mortgage calculator.com. How many dollars is $.000 in the bank and plan to save $500 a month. What is the formula for the two-year discount factor. If the discount rate is 14%. If the interest rate is 9%.000 at an interest rate of 10%. Suppose that you have $5. After that. what is the PV of the stream of dividend payments? . Suppose that you take out a 30-year mortgage loan of $200. DF2? (page 37) 3. If the PV of $139 is $125.smartmoney. A project produces a cash flow of $432 in year 1.smartmoney. At an interest rate of 12%. (Note: for both calculators the annual rate is quoted as 12 times the monthly rate. Write down the formula for the present value of an investment that produces cash flows of Cl' C2 and C3• (page 37) 2. WEB PROJECTS There are dozens of Web sites that provide calculators to help with personal financial decisions. how much will you have at the end of eight years? 6. If the cost of capital is 15%.507.

Year 10 (at a discount rate of 13%). calculate the three-year discount factor. 14. amounting to $2.. Year 15 (at a discount rate of 25%). . c. The cost of anew automobile is $10. what is the two-year discount factor? c.000. staiJ1ting immediately and continuing for 15 years? 11. how much would remain at the end of the six years? 10.905.000. You are quoted an interest rate of 6% on an investment of $10 million. a. If the first year's income is $10. What is the PV of $100 received in: a. What is the valu€ of your investment after four years if interest is compounded: a. The value of an asset that appre~ates at 10% per alU1ULUpproximately ~oubles in a seven years.colTl/b mase. You invest $1. how much do you need to set aside today to cover these bills? c.476 at 8%.000 and is expected to produce the following cash flows: Year Cash flow ($OOOs) 1 PRACTICE QUESTIONS 50 2 57 3 75 4 80 5 85 6 92 7 92 8 80 9 68 10 50 Visit us at .000 a year for 10 years. What is the PV of a continuous stream of cash flows.000 per year. A machine costs $380. what is the net present value of the factory? VVhatwill the factory be worth at the end of five years? 15.000 at this rate. The continuously compounded interest rate is 12%. A piece of land produces an income that grows by 5% per annum. 1£ the cost of capital is 12%. What is the PV of an asset that pays $1 a year in perpetuity? How to Calculate Present Values 55 b. a. You ha ve to pay $12.5'%. 13. is the approximate PV of an asset that pays $1 a year for each of the next seven years? d.. If the two-year interest rate is 10. You reckon that it will produce an inflow after operating costs of $170. what is the value of the land? What 9. A factory costs $800. a. what is the one-year interest rate? b. Monthly? or c. what is the three-year annuity factor? e.CHAPTER 3 The interest rate is ] 0%. Continuously? 12. a.000.000 a year in school fees at the end of each of the next six years. mIlhe.. how much would you have to set aside now to provide this sum in five years? b. what is the machine's NPV? . After paying the above school fees.65. If the interest rate is 8%. If the PV of $10 a year for three years is $24. calculate the two-year annuity factor.and two-year discount factors. Each of years 1 through 3 (at a discount rate of 12%). d. If the one-year discount factor is . What is the PV of $5 million to be received in eight years? c. b. What is the approximate PV of an asset that pays $1 a year In perpetuitv beginning in year 87 c. d. Year 10 (at a discount rate of 1%). Annually? b. If the opportunity cost of capital is 14"/0. Given these one.U the interest rate is 5%. From your answers to (c) and (d).ww. You have invested $60. What is the investment worth after five years? b.

Calculate the NPV. $180. Mike forecasts that his salary will increase at a steady rate of 5% per annum until his retirement at age 60.400 a year forever. Kangaroo Autos is offering free credit on a new $10. a. Refer back to Section 3. If the boat costs $20. If Mike plans to spend these savings in even amounts over the subsequent 20 years. b. As winner of a breakfast cereal competition. A perpetuity that pays $1 billion at the end of the first year and that grows at4% a year. After 15 years. b. Lines is considering the purchase of a new bulk carrier for $8 million. d. He wishes to invest $20. Basset expect to receive each year? 21. h. 24. An investment that offers you $100 a year in perpetuity with the payment at the end of each year. how much will he have saved by age 60? c.mhhe.000 in year 3.000 in year 2. You pay $1.000.000 in year 1.comlbma9. $100. 23.e.000 and they can earn 10% a year on their savings.000 down and then $300 a month for the next 30 months. If Mike saves 5% of his salary each year and invests these savings at an interest rate of 8%.000 in an annuity that will make a level payment at the end of each year until his death. c. what is the ship's NPV? a.56 PART ONE Value 16. how much can he spend each year? 17. what income can Mr. $11.000 car. A factory costs $400. If the interest rate is 7%. what is the PV of these future salary payments? b.5 million.000 at the end of five years.000 now. If the discount rate is 8%. If the rate of interest is 8% rather than 10%.500 next year and increasing thereafter by 5% a year forever. (about . what is the value of the following three investments? a. and $300.2. 10. If the interest rate is 12%. If the discount rate is 8%. the ship is expected to be sold for scrap at $1. and 15%. Plot the points on a graph with NPV on the vertical axis and the discount rates on the horizontal axis. Siegfried Basset is 65 years of age and has a life expectancy of 12 more years. $6. The forecasted revenues are $5 million a year and operating costs are $4 million. A major refit costing $2 million will be required after both the fifth and tenth years. A similar investment with the payment at the beginning of each year.000.000 off the list price. $200. If the interest rate is 8%. you can choose one of the following prizes: . e. $19. David and Helen Zhang are saving to buy a boat at the end of five years. which is the most valuable prize? 20. It will produce an inflow after operating costs of $100.000 for each of 10 years. A similar investment with the payment spread evenly over each year. 19. If the rate of interest is 10% a yem. how much do they need to put aside at the end of years 1 through 5? 22. Recalculate the NPV of the office building venture in Section 31 at interest rates of 5. Turtle Motors next door does not offer free credit but will give you $1.83% a month) which company is offering the better deal? . Mike Polanski is 30 years of age and his salary next year will be $40. $1 billion at the end of each year in perpetuity. The opportunity cost of capital is 12%. @ Halcyon ViSit us 01 www. how much would you need to set aside to provide each of the following? a. 25. c. At what discount rate (approximately) would the project have zero NPV? Check your answer.

. how much would you have been prepared to bid for the prize? b. you will have accumulated sav\.$1billion a year spread evenly over 20 years. ~ u have just read an advertisement stating. "Pay us $100 a year for 10 years and we \\~11pay you $100 a year thereafter in perpetuity. If the interest rate is 8% and you live 15 years after retirement.. In 1880 five aboriginal trackers were each promised the equivalent of 100 Australian dollars fOll helping to capture the notorious outlaw Ned Kelley. The prize was $9. the interest payment on the loan.. at 18 months.000 at the end of each of the next eight years.5%._ 31. 'lPel Visit us al \lfww. everal years ago The Wall Street [oumal reported that the winner of the Massachusetts State Lottery prize had the misfortune to be both bankrupt and in prison for fraud. 32.5% compounded continuously. What is the PV of these payments if the annual discount rate is 8%? . The prime minister of Victoria stated that. b.. to be paid in 19 equal annual installments. the government would be happy to pay the $100.e. You estimate that by the time you retire in 35 years. In 1993 the granddaughters of two of the trackers claimed that this reward had not been paid. if this was true. Calculate for each year the loan balance that remains outstanding..~ .000 per year. a. The first payment arrives in six months. An investment paying interest of 12% compounded annually.000 and nine subsequent $100.). (There were 20 installments. 29. Calculate PV for each of the following cases.5. inflation will eat into the value of your retirement income. The interest rate is 8%. i'.2 million. TIle first payment arrives one year from now. An investment paying 11.. a. -··-/ings of $2 million.t was 10%? 30. uch will you have at the end of 20 years if you invest $100 today at 15% annually ow ~'''''ded7 How much will you have if you invest at 15% continuously compounded? . what annual level of expenditure will those savings support? Unfortunately. etc.713. A mortgage requires you to pay $70.. 30 months. How much was each entitled to if the interest rate was 5%? What ii£ri. and 20 years. Enhance Reinsurance Company was reported to have offered $4.420. If the interest rate was 8%. c. ( 33. The annually compounded discount rate is 5. The annuity payments arrive at one-year intervals. the granddaughters also claimed that they were entitled to compound interest. 34. An investment paying interest of 11. $1 uuon snu at the end of each year for 20 years.000semiannual payments at six-month intervals. Following payments arrive at one-year intervals (i. but the wilmer had already received the first payment..7% compounded semiannually. Work out the value of each of these investments after 1. and the reduction in the loan balance. What is the present value of these payments? b.:Ja.comlbm~t~l8.) The bankruptcy eourt judge ruled that the prize should be sold off to the highest bidder and the proceeds used to payoff the creditors. a.. wha t is the ra te of interest? ~Which would you prefer? \~:~. You are asked to calculate the present value of a 12-year annuity with payments of $50.CHAPTER 3 How to Calculate Present Values 57 Co ~ compOLil' . Use Excel to find the return that the company was looking for. Assume a 4% inflation rate and work out a spending program for your retirement that will allow you to increase your expenditure in line with inflation." If this is a fair deal. A leasing contract calls for an immediate payment of $100.rllhhe. b. However.

tax-free municipal-bond mutual fund. Luxury Challenged Marblehead. use the Rule of 72 to calculate roughly how long it takes before your money doubles. My spouse and I are each 62 and hope to retire in three years. . and it is expected to last for a very long time. The pipeline's operating costs are negligible. b. Here are two useful rules of thumb. We have $1. vVhat is the PV of the pipeline's cash flows if its cash flows are assumed to last forever? b. Unfortunately our monthly living expenses are $15. the volume of oil shipped is declining.comlbrnage. The "Rule of 69" says that with continuous ·compounding the time that it takes to double is exactly 69. What is the PV of the cash flows if the pipeline is scrapped after 20 years? :.58 PART ONE Value 35. The "Rule of 72" says that with discrete compounding the time it takes for an investment to double in value is roughly 72/interest rate (in percent). The discount rate is 10%..3/interest rate (in percent). Use Excel to construct your own set of annuity tables.. CHALLENGE QUESTIONS 36.000. Can you prove the Rule of 697 reI 37.. Dear Financial Adviser. a. We plan to make annual withdrawals from the mutual fund to cover the difference between our pension and Social Security income and our living expenses. . If the annually compounded interest rate is 12%. and cash flows are expected to decline by 4% per year.. The return on the fund is 3. You own an oil pipeline which will generate a $2 million cash return over the coming year.mMe. After retirement we will receive $7.500 per month after taxes from Social Security..000 invested in a high-grade. a. MA You can assume that the withdrawals (one per year) will sit in a checking account (no interest).5% per year.500 per month after taxes from our employers' pension plans and $1. How many years before we run out of money? Sincerely. Now work it out exactly. The couple will use the account to cover the monthly shortfalls.000. Unfortunately. \lisit ~ 'iii :l . rg VI us at www. Our social obligations preclude further economies.