2- 1

Future Values
Future Value of Rs.100 = FV

FV ! Rs.100 v (1  r )

t

McGraw-Hill/Irwin

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved

100v(1r) Example What is the future value of s.400. All rights reserved 1 .000 if interest is compounded annually at a rate of 5% for one year? t FV ! Rs.400.2.420.2 Future Values ! s. 000 v (1  .05) ! Rs. Inc. 000 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies.

Inc. All rights reserved .2.3 Present Value Present Value PV PV discount actor v C1 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies.

4 Present Value Discount Factor = DF = PV of Rs. Inc.2. All rights reserved . McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies.1 DF ! 1 t (1 r ) Discount Factors can be used to compute the present value of any cash flow.

All rights reserved . then Cost of capital = r = 5% McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. Inc.5 Valuing an Office Building Step 1: Forecast cash flows Cost of building = C0 = 400 Sale price in Year 1 = C1 = 420 Step 2: Estimate opportunity cost of capital If equally risky investments in the capital market offer a return of 5%.2.

05) ! 400 Step 4: Go ahead if PV of payoff exceeds investment NPV ! 400 370! 30 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. All rights reserved . Inc.6 Valuing an Office Building Step 3: Discount future cash flows PV ! C1 (1r ) ! 420 (1.2.

Inc. All rights reserved .required investment C1 C0  1 r NP McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies.7 Net Present Value NP P .2.

Inc.2.420 at 5 420 ! 400 PV ! 1  .8 Risk and Present Value  Higher risk projects require a higher rate of return  Higher required rates of return cause lower PVs PV of C1 ! s. All rights reserved .05 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies.

420 at 5 420 ! 400 PV ! 1  .05 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies.420 at 12% 420 PV ! ! 375 1  . Inc.2. All rights reserved .9 Risk and Present Value PV of C1 ! Rs.12 PV o C1 ! Rs.

000 ! Rs.000-370.2.5. Inc.000 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. All rights reserved .10 Risk and Net Present Value NPV PV-required investment NPV 375.

11 Rate of Return Rule  Accept investments that offer rates of return in excess of their opportunity cost of capital Example In the project listed below.000 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. All rights reserved .5% investment 370.000 Return ! ! ! .000  370. Should we do the project? profit 420.2. Inc. the foregone investment opportunity is 12%.135 or 13.

12 Net Present Value Rule  Accept investments that have positive net present value Example Suppose we can invest Rs.55 1.50 today and receive Rs.2.10 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. Inc. All rights reserved .4. Should we accept the project given a 10% expected return? 60 NPV=-50+ ! Rs.60 in one year.

Depending on the state of the economy.000 C1 80. 000  140.000 110. you may get one of three possible cash payoffs: Economy Payoff Expected payoff Slump Normal Boom Rs.000 140.100. 000  110.2.13 Opportunity Cost of Capital Example You may invest Rs. Inc. 000 3 Rs. All rights reserved . 000 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies.000 today.110.80.

95.continued The stock is trading for Rs. All rights reserved .65. is forecast at Rs.14 Opportunity Cost of Capital Example . given a normal economy.110 The stocks expected payoff leads to an expected return.65 Expected return ! ! ! . Inc.15 or 15 investment 95.2. Next year¶s price. expected profit 110  95.65 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies.

650 1.95. All rights reserved .continued Discounting the expected payoff at the expected return leads to the PV of the project 110.2.15 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies. Inc.000 PV ! ! s.15 Opportunity Cost of Capital Example .

expected profit 110.000 Expected return ! ! ! .16 Opportunity Cost of Capital Example .10 or 10% investment 100. All rights reserved .000  100.2. Inc.000 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies.continued Notice that you come to the same conclusion if you compare the expected project return with the cost of capital.

200. Each invests Rs.185. The ant (A) wants to wait. Inc.17 Investment vs. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies.000 at the end of the year.210. The existence of capital markets allows G to consume now and still invest with A in the project. But each is happy to invest. All rights reserved .000 and repays Rs.000 and returns Rs.000 at the end of the year.2. G wants to consume now so G borrows Rs. Consumption The grasshopper (G) wants to consume now.210.

All rights reserved .000 at the end of the year.000 at the end of the year. Consumption Rupees Next Year 210 A invests Rs.000 and returns Rs. But each is happy to invest.210.2. The ant (A) wants to wait.185 now.210.18 Investment vs.200. 194 G invests Rs.200 and consumes now. borrows Rs. Inc. Rupees Now 185 McGraw-Hill/Irwin 200 Copyright © 2006 by The McGraw-Hill Companies.210 next year  The grasshopper (G) wants to consume now. G wants to consume now so G borrows Rs.185 now and consumes Rs. Each invests Rs.000 and repays Rs. The existence of capital markets allows G to consume now and still invest with A in the project.185.

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