Last Study Topics What Is A Corporation? - All large and medium-sized businesses are organized as corporations. The Role of The Financial Manager - Capital Budgeting vs Financing Decision. Who Is The Financial Manager? -Anyone responsible for a significant investment or financing decisions. Separation of Ownership and Management Financial Markets 11/14/2014Instructor: Mr. Wajid Shakeel Ahmed1

 Present Value and The Opportunity Cost of Capital Principles of Corporate Finance Brealey and Myers Sixth Edition © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill

Topics Covered Present Value (PV) Net Present Value (NPV) NPV Rule Rate Of Return Rule Opportunity Cost of Capital Managers and the Interests of Shareholders 11/14/20143Instructor: Mr. Wajid Shakeel Ahmed

Introduction COMPANIES INVEST IN a variety of real assets. -Tangible Assets: such as plant and machinery. -Intangible Assets: such as management contracts and patents. Object of investment is to find real assets that are worth more than they cost. Companies are always searching for assets that are worth more to them than to others. 11/14/2014Instructor: Mr. Wajid Shakeel Ahmed4

Continue Suppose you own a warehouse. The odds are that your appraiser’s estimate of its value will be within a few percent of what the building would actually sell for. The appraiser’s stock-in-trade is knowledge of the prices at which similar properties have recently changed hands. Problem of valuing real estate is simplified by the existence of an active market. Or Is it not? 11/14/2014Instructor: Mr. Wajid Shakeel Ahmed5

Continue Answer to that would be; First, it is important to know how asset values are reached in an active market. Second, it is important to understand why that warehouse is worth, say, $250,000 and not a higher or lower figure. Thirdly, the market for most corporate assets is pretty thin. 11/14/2014Instructor: Mr. Wajid Shakeel Ahmed6

Continue In other words, you need a theory of value. Should you invest to build a new office building in the hope of selling it at a profit next year? Finance theory endorses investment if net present value is positive, that is, if the new building’s value today exceeds the required investment. 11/14/2014Instructor: Mr. Wajid Shakeel Ahmed7

Understanding the Present Value The present value of $400,000 one year from now must be less than $400,000. “A dollar today is worth more than a dollar tomorrow” - first basic principle of finance. 11/14/2014Instructor: Mr. Wajid Shakeel Ahmed8

Continue Present Value Value today of a future cash flow. Discount Rate Interest rate used to compute present values of future cash flows. Discount Factor Present value of a $1 future payment. 11/14/20149Instructor: Mr. Wajid Shakeel Ahmed

Continue Discount Factor = DF = PV of $1 Discount Factors can be used to compute the present value of any cash flow. 11/14/201410Instructor: Mr. Wajid Shakeel Ahmed

Case: Office Building Warehouse has burned down. You consider rebuilding, but your real estate adviser suggests putting up an office building instead. The construction cost would be $300,000, and there would also be the cost of the land, which might otherwise be sold for $50,000. new building would fetch $400,000 if you sold it after an year. Is it worth to go ahead with the investment plan? or not? 11/14/2014Instructor: Mr. Wajid Shakeel Ahmed11

Valuing an Office Building Step 1: Forecast cash flows (,000) Cost of building = C 0 = $350 Sale price in Year 1 = C 1 = $400 Assuming for the moment that the $400,000 payoff is a sure thing. 11/14/201412Instructor: Mr. Wajid Shakeel Ahmed

Continue Step 2: Estimate opportunity cost of capital If equally risky investments in the capital market offer a return of 7%, how much would you have to invest in them in order to receive $400,000 at the end of the year? Lets find out! 11/14/2014Instructor: Mr. Wajid Shakeel Ahmed13

Valuing an Office Building Step 3: Discount future cash flows (,000) Since the property will be worth $400,000 in a year, investors would be willing to pay $374,000 for it today. 11/14/201414Instructor: Mr. Wajid Shakeel Ahmed

Continue We have discounted expected payoffs by the rate of return offered by equivalent investment alternatives in the capital market, i.e. offer a return of 7%. This rate of return is often referred to as the discount rate, hurdle rate, or opportunity cost of capital. 11/14/2014Instructor: Mr. Wajid Shakeel Ahmed15

Net Present Value 11/14/201416Instructor: Mr. Wajid Shakeel Ahmed

Continue Step 4: Go ahead if PV of payoff exceeds investment NPV = PV - required investment = 374, ,000 = $24,000. In other words, your office development is worth more than it costs—it makes a net contribution to value. 11/14/2014Instructor: Mr. Wajid Shakeel Ahmed17

Risk and Present Value Higher risk projects require a higher rate of return. Higher required rates of return cause lower PVs. 11/14/201418Instructor: Mr. Wajid Shakeel Ahmed

Risk and Present Value Suppose you believe the project is as risky as investment in the stock market and that stock market investments are forecasted to return 12 percent. Then 12 percent becomes the appropriate opportunity cost of capital. That is what you are giving up by not investing in equally risky securities. 11/14/2014Instructor: Mr. Wajid Shakeel Ahmed19

Risk and Present Value 11/14/201420Instructor: Mr. Wajid Shakeel Ahmed Re-compute; NPV = PV-350 =$7

Rate of Return Rule Accept investments that offer rates of return in excess of their opportunity cost of capital 11/14/201421Instructor: Mr. Wajid Shakeel Ahmed

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? 11/14/201422Instructor: Mr. Wajid Shakeel Ahmed

Explanation One cannot be certain about future values of office buildings. The $400,000 represents the best forecast, but it is not a sure thing. A safe dollar is worth more than a risky one. Most investors avoid risk when they can do so without sacrificing return. 11/14/2014Instructor: Mr. Wajid Shakeel Ahmed23

Case: Motel Building Aparcel of land costs $500,000. For an additional $800,000 you can build a motel on the property. The land and motel should be worth $1,500,000 next year. Suppose that common stocks with the same risk as this investment offer a 10 percent expected return. Would you construct the motel? Why or why not? 11/14/2014Instructor: Mr. Wajid Shakeel Ahmed24

Valuing a Motel Building Step 1: Forecast cash flows (,000) Cost of building = C 0 = $1300 Sale price in Year 1 = C 1 = $1500 Assuming for the moment that the $1500,000 payoff is a sure thing. 11/14/201425Instructor: Mr. Wajid Shakeel Ahmed

Continue Step 2: Estimate opportunity cost of capital A Common Stock with a same risk as this investments in the capital market offer a return of 10%, how much would you have to invest in them in order to receive $1500,000 at the end Of the year? Lets find out! 11/14/2014Instructor: Mr. Wajid Shakeel Ahmed26

Continue To calculate present value, we discount expected payoffs by the rate of return offered by equivalent investment alternatives in the capital market, i.e. offer a return of 10%. This rate of return is often referred to as the discount rate, hurdle rate, or opportunity cost of capital. 11/14/2014Instructor: Mr. Wajid Shakeel Ahmed27

Valuing an Motel Building Step 3: Discount future cash flows (,000) Since the property will be worth $1500,000 in a year, investors would be willing to pay $1364,000 for it today 11/14/201428Instructor: Mr. Wajid Shakeel Ahmed

Continue Step 4: Go ahead if PV of payoff exceeds investment NPV = PV - required investment = 1364, ,000 = $64,000. In other words, your motel development is worth more than it costs—it makes a net contribution to value. 11/14/2014Instructor: Mr. Wajid Shakeel Ahmed29

Alternative we can compute r as follows: r = ($1,500,000/$1,300,000) – 1 = = 15.38% Since - Rate of Return is > Cost of Capital, you would still construct the motel. 11/14/2014Instructor: Mr. Wajid Shakeel Ahmed30

Understanding NPV and ROR Let INV = investment required at time t = 0 (i.e., INV = -C 0 ) and let x = rate of return. Then x is defined as: x = (C 1 – INV)/INV Therefore: C 1 = INV(1 + x) 11/14/2014Instructor: Mr. Wajid Shakeel Ahmed31

Continue It follows that: NPV = C 0 + {C 1 /(1 + r)} NPV = -INV + {[INV(1 + x)]/(1 + r)} NPV = INV {[(1 + x)/(1 + r)] – 1} 11/14/2014Instructor: Mr. Wajid Shakeel Ahmed32

Continue a. When x equals r, then: [(1 + x)/(1 +r)] – 1 = 0 and NPV is zero. b. When x exceeds r, then: [(1 + x)/(1 + r)] – 1 > 0 and NPV is positive. 11/14/2014Instructor: Mr. Wajid Shakeel Ahmed33

Case: Pakistan Treasury security What is the net present value of a firm’s investment in a Pakistan Treasury security with the face value of Rs yielding 5 percent and maturing in one year? Solution: NPV = C 0 + [C 1 /(1 + r)] = Rs (1050/1.05) = Rs. 0 11/14/2014Instructor: Mr. Wajid Shakeel Ahmed34

Explanation This is not a surprising result, because 5 percent is the opportunity cost of capital, i.e., 5 percent is the return available in the capital market. If any investment earns a ‘rate of return’ equal to the ‘opportunity cost of capital’, the NPV of that investment is zero. 11/14/2014Instructor: Mr. Wajid Shakeel Ahmed35

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% expected return? 11/14/201436Instructor: Mr. Wajid Shakeel Ahmed

Summary Present Value (PV) – “A dollar today is worth more than a dollar tomorrow” Net Present Value (NPV) – If your investment makes a net contribution to value NPV Rule Rate Of Return Rule 11/14/2014Instructor: Mr. Wajid Shakeel Ahmed37