Chapter 2

Principles of Corporate Finance, 8/e

(Special Indian Edition)

Present Values, the Objectives of the Firm, and Corporate Governance

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Topics Covered
Introduction to Present Value Foundations of the Net Present Value Rule Corporate Goals and Corporate Governance

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Present and Future Value

Future Value Amount to which an investment will grow after earning interest Present Value Value today of a future cash flow.

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Discount Factors and Rates

Discount Rate Interest rate used to compute present values of future cash flows.

Discount Factor Present value of a Rs.1 future payment.

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Future Values
Future Value of Rs.100 = FV

FV Rs.100 (1 r )

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Future Values
FV Rs.100 (1 r )
Example - FV
t

What is the future value of Rs.400,000 if interest is compounded annually at a rate of 5% for one year?

FV Rs.400,000 (1 .05) Rs.420,000

1

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Present Value

Present Value = PV PV = discount factor C1

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Present Value
Discount Factor = DF = PV of Rs.1

DF

1 (1 r ) t

Discount Factors can be used to compute the present value of any cash flow.

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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%, then Cost of capital = r = 5%

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Valuing an Office Building

Step 3: Discount future cash flows

PV

C1 (1r )

420 (1.05)

400

Step 4: Go ahead if PV of payoff exceeds investment

NPV 400 370 30

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Net Present Value

NPV = PV - required investment C1 NPV = C0 1 r

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Risk and Present Value

Higher risk projects require a higher rate of return Higher required rates of return cause lower PVs

PV of C1 Rs.420 at 5% 420 PV 400 1 .05

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Risk and Present Value

PV of C1 Rs.420 at 12% 420 PV 375 1 .12

PV of C1 Rs.420 at 5% 420 PV 400 1 .05

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Risk and Net Present Value

NPV=PV-required investment NPV=375,000-370,000 Rs.5,000

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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, the foregone investment opportunity is 12%. Should we do the project?
profit 420,000 370,000 Return .135 or 13.5% investment 370,000

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Net Present Value Rule

Accept investments that have positive net present value
Example Suppose we can invest Rs.50 today and receive Rs.60 in one year. Should we accept the project given a 10% expected return?

60 NPV=-50+ Rs.4.55 1.10

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Opportunity Cost of Capital

Example You may invest Rs.100,000 today. Depending on the state of the economy, you may get one of three possible cash payoffs:

Economy Payoff

Slump

Normal

Boom

Rs.80,000 110,000 140,000

80, 000 110, 000 140, 000 Expected payoff C1 Rs.110, 000 3

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Opportunity Cost of Capital

Example - continued The stock is trading for Rs.95.65. Next years price, given a normal economy, is forecast at Rs.110

expected profit 110 95.65 Expected return .15 or 15% investment 95.65

The stocks expected payoff leads to an expected return.

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Opportunity Cost of Capital

Example - continued Discounting the expected payoff at the expected return leads to the PV of the project

110,000 PV Rs.95, 650 1.15

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Opportunity Cost of Capital

Example - continued Notice that you come to the same conclusion if you compare the expected project return with the cost of capital.

expected profit 110,000 100,000 Expected return .10 or 10% investment 100,000

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Investment vs. Consumption

Some people prefer to consume now. Some prefer to invest now and consume later. Borrowing and lending allows us to reconcile these opposing desires which may exist within the firms shareholders.

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Investment vs. Consumption

income in period 1 100 An

80 Some investors will prefer A and others B

60

40

Bn

20

20

40 60 income in period 0

80

100

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Investment vs. Consumption

The grasshopper (G) wants to consume now. The ant (A) wants to wait. But each is happy to invest. Each invests Rs.185,000 and returns Rs.210,000 at the end of the year. G wants to consume now so G borrows Rs.200,000 and repays Rs.210,000 at the end of the year. The existence of capital markets allows G to consume now and still invest with A in the project.

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Investment vs. Consumption

Rupees Next Year 210 A invests Rs.185 now and consumes Rs.210 next year
The grasshopper (G) wants to consume now. The ant (A) wants to wait. But each is happy to invest. Each invests Rs.185,000 and returns Rs.210,000 at the end of the year. G wants to consume now so G borrows Rs.200,000 and repays Rs.210,000 at the end of the year. The existence of capital markets allows G to consume now and still invest with A in the project.

194

G invests Rs.185 now, borrows Rs.200 and consumes now. Rupees Now

185

200

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Managers and Shareholder Interests

Tools to Ensure Management Pays Attention to the Value of the Firm
Mangers actions are subject to the scrutiny of the board of directors. Shirkers are likely to find they are ousted by more energetic managers. Financial incentives such as stock options

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Whose Company Is It?

** Survey of 378 managers from 5 countries

Japan Germany France United Kingdom United States

0
The Shareholders All Stakeholders

3 17 22 71 76 40 60 80

97 83 78 29 24 20

100

120

% of responses

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Dividends vs. Jobs

** Survey of 399 managers from 5 countries. Which is more important...jobs or paying dividends?

Japan Germany France United Kingdom United States

0
Dividends Job Security

3 40 41

97 60 59 89 89 40 60 80 100 120

11 11 20

% of responses

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Goals of The Corporation

Shareholders desire wealth maximization Do managers maximize shareholder wealth? Mangers have many constituencies stakeholders Agency Problems represent the conflict of interest between management and owners

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Goals of The Corporation

Agency Problem Solutions 1 - Compensation plans 2 - Board of Directors 3 - Takeovers 4 - Specialist Monitoring 5 - Auditors

Corporate Governance Problem in India

Prof. J R Varma of IIM Ahmedabad has observed that the corporate governance problem in India is completely different from that of the AngloAmerican system. In India, there is a conflict of interest between the promoter shareholders (who mostly control the management) and the public shareholders. So it would be foolish to expect the Board in India to discipline the shareholders from whom it derives all its powers

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Web Resources
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www.smartmoney.com www.moneychimp.com/features/rule72.htm www.mhhe.com/business/finance/corpfinonline www.bankrate.com/brm/default.asp www.financenter.com