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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 22
© Professor HoMou 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 5percent, your investment
be worth $9,523.81 in today’s dollars.
05 . 1
000 , 10 $
81 . 523 , 9 $ ·
Corporate Finance 23
© Professor HoMou 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 5percent 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 24
© Professor HoMou 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 25
© Professor HoMou Wu
Net Present Value as the Investment Criterion
In the oneperiod 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 5percent, 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 26
© Professor HoMou 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 27
© Professor HoMou 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 28
© Professor HoMou 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 29
© Professor HoMou 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 210
© Professor HoMou 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 211
© Professor HoMou 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 212
© Professor HoMou 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 213
© Professor HoMou 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 214
© Professor HoMou 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 215
© Professor HoMou 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 216
© Professor HoMou 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 twoperiod 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 217
© Professor HoMou 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 218
© Professor HoMou 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 219
© Professor HoMou 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 220
© Professor HoMou 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 221
© Professor HoMou 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 222
© Professor HoMou 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 223
© Professor HoMou 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 224
© Professor HoMou 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 225
© Professor HoMou 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)
T1
Corporate Finance 226
© Professor HoMou 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..
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 5percent, your investment be worth $9,523.81 in today’s dollars.
$10,000 $9,523.81 = 1.05
© Professor HoMou Wu Corporate Finance
22
your investment would grow to $10.05).500 : $10.1 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 $10.000.000×(1. © Professor HoMou Wu Corporate Finance 23 . The total amount due at the end of the investment is call the Future Value (FV).000 = $9. Note that $10.000 in one year is call the Present Value (PV) of $10.05).2.81×(1.523. • If you were to invest $10.500 = $10.000 at 5percent interest for one year.
Net Present Value • The Net Present Value (NPV) of an investment is the present value of the expected cash flows.523. less the cost of the investment. Back to Example 1: $10.81 : So you should Invest.05 NPV = −$9.000 NPV = −$9.500 + $9.500 + 1.81 NPV = $23. 24 © Professor HoMou Wu Corporate Finance .
© Professor HoMou Wu Corporate Finance 25 .where CF1 is cash flow at date 1 1+ r NPV = −Cost + PV If we had not undertaken the positive NPV project considered on the last slide.500×(1. and instead invested our $9.000 that investment promised and we would be unambiguously worse off in FV terms as well: $9.000. our FV would be less than the $10. the formula for NPV can be written as: CF1 PV = .500 elsewhere at 5percent.975 < $10.05) = $9.Net Present Value as the Investment Criterion In the oneperiod case.
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 Y1=1.2.2m 1+r 1 B Y slope = (1+r) Spender (borrowing) A C0 26 © Professor HoMou Wu Y0=1m Y PV (Y ) = Y0 + 1 (1 + r ) Corporate Finance C0 .
C1) feasible? There is only one interest rate in the perfect capital market.2m C1 = 1.(I) Saving (Financing) Decision Y0 = 1m ， Consumption C： C 0 = 0. then C is feasible.2＋(1－C0)(1＋r) Spender (C0＞1m)：C1 ≤ 1. Saver (C0＜1m)：C1 ≤ 1.325m Is C＝(C0. ⇒ Same equation C1 ≤ Y1＋(Y0－C0)(1＋r) © Professor HoMou Wu Corporate Finance 27 . (1 + r ) (1 + r ) If PV(C) ≤ PV(Y).9m Income Y： Y1 = 1.2－(C0－1)(1＋r) C1 Y1 or C 0 + ≤ Y0 + .
0.919 ＝ PV(C) ＜ 1 ＋ Corporate Finance ＝ 1.2 1 : not feasible .325 1 Use ＝ 10%.2 1.105 it. 0.325m feasible? 1.2 ＋ the PV 0.923 28 .1 1.9 ＋ If r ＝ 2.Use PV to Check Feasibility of Consumption plan Example 2: Is the consumption plan C0 ＝ 0.2 If r ＝ 20%.325 1.3 1.1 1.2 ＝ 2.091 ＝ PV(Y) 1 . formula to evaluate ＝ PV(C) ＞.325 1 . 1 ＝ 2.9 ＋ © Professor HoMou ＝ PV(Y) Wu ＝ 1.004 ＝ PV(C) ＞ 1 ＋ 1.3 1 : not feasible .9 ＋ ＝ PV(Y) ＝ 2.9m and C1 ＝ 1.000 If r ＝ 30%.
The spender and saver will not agree on the choice of the best investment plan (A≠ B). © Professor HoMou Wu Corporate Finance Y1 (Y0.(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.Y1). output input C 1 Saver B Both consume what they produce where E－Y0＝input and Y1＝output. Spender A Y0 E 29 .
All shareholders agree on their preference for positive NPV projects. © Professor HoMou Wu Corporate Finance 210 . whether they are borrowers or lenders. which is unambiguously good.Corporate Investment Decision‑Making Consumption at t+1 Positive NPV projects shift the shareholder’s opportunity set out.
but D is not the optimal investment plan yet. its owners can then use financial markets for saving or borrowing. as represented by the dotted straight line. B D slope = (1+r) A E PV(D) C0 © Professor HoMou Wu Corporate Finance 211 . Both investors are happier than in (Ⅱ).(Ⅲ) Investment Opportunities with Financial Markets Financial markets present saving/borrowing C1 opportunities. Suppose the company (farm) chooses D.
Y0 C1 B’ Y* slope = (1+r) Y1 D A’ E PV(Y) C0 © Professor HoMou Wu Corporate Finance 212 .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). Perfect capital market (borrowing rate ＝ lending rate) is assumed.
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 Investment Decision‑Making • In reality. © Professor HoMou Wu Corporate Finance 213 .
the best investment plan is the one that maximizes NPV(Y). and the best investment plan is independent of investors’ preferences. PV ＝ CF3 CF1 CF2 + + + 2 3 1 + r (1 + r ) (1 + r ) CF3 CF1 CF2 + + + ⋅⋅⋅ NPV ＝− CF0 + 2 3 1 + r (1 + r ) (1 + r ) − CF0 + ＝ PV 214 © Professor HoMou Wu Corporate Finance .Optimal Investment Plan Y1 Y1 − = (Y0 + )−E Net Present Value NPV ＝ ( E − Y0 ) + 1+ r 1+ r input ＝ PV(Y) － E Therefore.
© Professor HoMou Wu Corporate Finance 215 .Fisher’s Separation Principle Given perfect capital market and certainty. (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. 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.
Which is the best project? Payoffs Investment next period 1 25m 30m 2 50m 100m 3 100m 160m © Professor HoMou Wu Corporate Finance 216 .Why do we use NPV or PV as investment criterion Example 3. What is not invested will be consumed. Is it a good investment project when r＝6%? Example 4. A project which requires $650m investment will have payoffs $300m and $400m in the next two years. Consider a twoperiod world with an interest rate of 25%. Suppose you have a fund of $100m and can choose one from the following three projects.
25＝130* 30* 3 0 160 0＋160/1.06 Example 4(continued): NPV Y0 Y1 PV(Y) ＝PV－E 75＋30/1.25＝99 1 75 30 1 2 50 100 50＋100/1.NPV as Investment Criterion Example 3(continued): NPV＝ − 650 + 300 + 400 ＝ − 650 + 283 + 356 = −11 < 0 1.25 ＝50＋100/1.25 CF1 1+ r © Professor HoMou Wu Corporate Finance 217 .25＝128 28 ＝CF0＋ ＝25＋30/1.06 1.25 ＝100＋160/1.
943.3 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 $20.2.000 5 $20.000 $9.15) 5 © Professor HoMou Wu Corporate Finance 218 .53 = (1.
10) = =2 $5.000 = $5.000 (1.6931 T= = = 7.How Long is the Wait? Example 5: If we deposit $5.0953 © Professor HoMou Wu Corporate Finance 219 .10)T = ln 2 ln 2 0.000 today in an account paying 10%.000? FV = CF0 × (1 + r ) T $10.27 years ln(1. how long does it take to grow to $10.000 T ln(1.10) T $10.10) 0.000 × (1.
000 (1 + r ) = = 10 $5. You have $5.2115 Corporate Finance 220 .000 12 $50.000 × (1 + r )12 (1 + r ) = 101 12 r = 10 © Professor HoMou Wu 1 12 − 1 = 1.000 when your child enters college in 12 years.What Rate Is Enough? Example 6: Assume the total cost of a college education will be $50.000 = $5.000 to invest today. What rate of interest must you earn on your investment to cover the cost of your child’s education? FV = CF0 × (1 + r ) T $50.2115 − 1 = .
• Growing annuity – A stream of cash flows that grows at a constant rate for a fixed number of periods.4 PV with Special Cash Flows • Perpetuity – A constant stream of cash flows that lasts forever. • Annuity – A stream of constant cash flows that lasts for a fixed number of periods. © Professor HoMou Wu Corporate Finance 221 .2. • Growing perpetuity – A stream of cash flows that grows at a constant rate forever.
C 0 1 C 2 C 3 … C C C PV = + + + 2 3 (1 + r ) (1 + r ) (1 + r ) The formula for the present value of a perpetuity is: © Professor HoMou Wu C PV = r Corporate Finance 222 .Perpetuity A constant stream of cash flows that lasts forever.
C 0 1 C×(1+g) 2 C ×(1+g)2 3 2 … C C × (1 + g ) C × (1 + g ) PV = + + + 2 3 (1 + r ) (1 + r ) (1 + r ) The formula for the present value of a growing perpetuity is: © Professor HoMou Wu C PV = r−g Corporate Finance 223 .Growing Perpetuity A growing stream of cash flows that lasts forever.
C C C C 0 1 2 3 T C C C C PV = + + + 2 3 T (1 + r ) (1 + r ) (1 + r ) (1 + r ) The formula for the present value of an annuity is: © Professor HoMou Wu C 1 PV = 1 − T r (1 + r ) Corporate Finance 224 .Annuity A constant stream of cash flows with a fixed maturity.
Growing Annuity A growing stream of cash flows with a fixed maturity. C C×(1+g) C ×(1+g)2 C×(1+g)T1 0 1 2 3 T C C × (1 + g ) C × (1 + g )T −1 PV = + ++ 2 T (1 + r ) (1 + r ) (1 + r ) The formula for the present value of a growing annuity: © Professor HoMou Wu 1 + g T C PV = 1 − (1 + r ) r−g Corporate Finance 225 .
a firm should be worth the present value of the firm’s cash flows. • The tricky part is determining the size.What Is a Firm Worth? • Conceptually. © Professor HoMou Wu Corporate Finance 226 .. timing and “risk” of those cash flows : we will probe further in later class.
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