Lect 1

Lecture 1: Present Value
Present Value
Introduction to Present Value
Foundations of the Net Present Value Rule
Based on Chapter 2 in BMA
FM212
Principles of Corporate Finance
12
Values and Discounting

Discount Rate
Interest rate used to compute present
values of future cash flows
Present Value
Value today of a
future cash flow
Future Value
Amount to which an
investment will grow
after earning interest
Discount Factor
Present value of a $1 future payment
FM212
13
Future Value
Future Value (FV) of $100:
FV current cash flows to their future
values
FV = $ 100 (1 + r )
FM212
14
Future Value
Example
What is the future value of $400,000 if
interest is paid annually at a rate of 5% for
one year?
FV = $400,000 (1 + .05) = $420,000
1
FM212
15
Present Value
Present Value (PV) converts future cash
flows to their current values
PV = discount factor C1
FM212
16
Discount Factor
Define Discount Factor (DF) as PV of $1
DF =
1
(1+ r) t
Discount Factors can be used to compute

the present value of any cash flow
FM212
17
Discount Rate
The discount rate is the reward investors
demand for accepting delayed payment.
Investors demand what they could receive
from risk-equivalent investment
alternatives.
Discount rate is also called opportunity
cost of capital because it is the return
foregone by investing in a capital project
rather than investing in freely-available
securities.
FM212
18
Quick Question
If the present value of 200 paid at the
end of one year is 178.57, what is the
one-year discount factor? What is the
discount rate?
FM212
19
Answer to the Quick Question

DF1= 178.57/200=0.893
Discount rate=1/0.893-1=12%
FM212
20
Net Present Value

Net present value is the present value of
all future cash flows minus the required
investment
C1
NPV =
Cost
1+ r
FM212
21
Example
Valuing an Office Building
Step 1: Forecast cash flows
Cost of building = 370
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%
FM212
22
Example (cntd)
Step 3: Discount future cash flows
PV =
C1
(1+r)
= (1420
+.05) = 400
Step 4: Subtract initial cost from PV to

determine if PV exceeds investment cost
NPV= 400 370= 30
FM212
23
Risk and Present Value

Higher risk projects require a higher rate
of return
Higher required rates of return cause
lower PVs
FM212
24
Example
PV of C1 = $420 at 5%
420
PV =
= 400
1 + .05
PV of C1 = $420 at 12%
420
PV =
= 375
1 + .12
FM212
25
Example (cntd)
NPV decreases as the discount rate
increases:
NPV= 400 370= 30

NPV= 375 370= 5
FM212
26
Technical Note on % Sign

1
5% means 5
100
2
1
2
5% means 5
= 25%% = .0025
100
Always eliminate % signs before the

beginning of calculations
5% 10% 50%, but 0.05 0.1=0.005
FM212
27
Net Present Value Rule

Accept investments that have positive net
present value
Example:
Suppose we can invest $50 today and
receive $60 in one year. Should we accept
the project given a 10% required return?
60
NPV = -50 +
= $ 4 . 55
1.10
FM212
28
Quick Question
A merchant pays 100,000 for a shipment
of Beaujolais dAnne and is certain that it
can be resold at the end of one year for
115,000.
What is the return on this investment?
If this return is lower than the rate of interest,
does the investment have a positive or a
negative NPV?
If the rate of interest is 10%, what is the PV of
the investment?
What is the NPV?
FM212
29
Answer to the Quick Question

Return=profit/investment=
(115,000-100,000)/100,000=15%
Negative (if the rate of interest equals
15%, NPV=0)
PV=115,000/1.10=104,545
NPV=104,545-100,000=4,545
FM212
30
Example
You can invest $100,000 today. Depending on
the state of the economy, you may get one of
three equally likely cash payoffs from this project:
Economy Slump Normal Boom

Payoff
$80,000 110,000 140,000
Should you invest given that there is a stock in
the market trading for $95.65 whose next years
price is forecast at $110 with no intervening
dividends.
FM212
31
Example (cntd)
Expected payoff of the project:
80,000 + 110,000 + 140,000
E(C1 ) =
= $110,000
3
Expected return of the stock:

expected profit 110 95.65
E(rs ) =
=
= .15 or 15%
investment
95.65
The stocks expected return is the

(opportunity) cost of capital of the project
FM212
32
Example (cntd)
Discounting the expected payoff at the cost
of capital leads to the PV of the project:
110,000
PV =
= $95,650
1.15
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
E(rp ) =
=
= .10 or 10%
investment
100,000
FM212
33
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
Shareholder composition should not affect
a firms cost of capital
FM212
34
Investment vs. Consumption

Income in period 1
100
A
80
Some investors will

prefer A and others B
60
40
B
20
Income in period 0
20
40
60
80
FM212
100
35
Example
George (G) wants to consume now. Anne
(A) wants to wait. But each is happy to
invest. Each invests $185,000 and returns
$210,000 at the end of the year. G wants
to consume now, so G borrows $200,000
and repays $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
FM212
36
Example (cntd)
A invests $185 now and
consumes $210 next year
Dollars Next Year
210
194
G invests $185 now, borrows

$200 and consumes now
185
200
FM212
Dollars Now
37

Lect 1

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Lect 1

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Lecture 1: Present Value

Based on Chapter 2 in BMA

Values and Discounting

Discount Factors can be used to compute

Answer to the Quick Question

Net Present Value

Step 2: Estimate opportunity cost of

Step 4: Subtract initial cost from PV to

NPV= 400 370= 30

Risk and Present Value

NPV= 400 370= 30

Technical Note on % Sign

Always eliminate % signs before the

Net Present Value Rule

Answer to the Quick Question

Economy Slump Normal Boom

Expected return of the stock:

The stocks expected return is the

Investment vs. Consumption

Investment vs. Consumption

Some investors will

G invests $185 now, borrows

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