Berlin, Fußzeile1 More About Present Values Applications: Concept of Net Present Values

Berlin, Fußzeile2 Valuing an Office Building Step 1: Forecast cash flows Cost of building = C 0 = 350 Sale price in Year 1 = C 1 = 400 Step 2: Estimate opportunity cost of capital If equally risky investments in the capital market offer a return of 7%, then Cost of capital = r = 7%

Berlin, Fußzeile3 Valuing an Office Building Step 3: Discount future cash flows Step 4: Go ahead if PV of payoff exceeds investment

Berlin, Fußzeile4 The Concept of Net Present Value

Berlin, Fußzeile5 Risk and Present Value  Higher risk projects require a higher rate of return  Higher required rates of return cause lower PVs

Berlin, Fußzeile6 Risk and Present Value The Higher the Risk, the Higher The Opportunity Cost of Capital i.e. The Higher The Requested Return

Berlin, Fußzeile7 Net Present Value Rule  Accept investments that have positive net present value:  If there are competing investment opportunities, select the one that offers the highest net present value:

Berlin, Fußzeile8 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?

Berlin, Fußzeile9 The Rate of Return Concept  Calculate the rate of return of your investment and check, if it exceeds the “required” return Example In the project listed below, the foregone investment opportunity is 12%. Should we do the project?

Berlin, Fußzeile10 Rate of Return Rule  Accept investments that offer rates of return in excess of their opportunity cost of capital r:  If there are competing investment opportunities, select the one that offers the highest rate of return:

Berlin, Fußzeile11 NPV Meets Value Maximization FIXED ASSETS EQUITY LIQUIDITY DEBT Market Values without Project A FIXED ASSETS EQUITY LIQUIDITY DEBT Market Values with Project A PV(CF) Proj.A Project A offers a perpetual future Cash Flow of 300 p.a. The initial Investment would be The interest rate is at 10%. The PV of future Cash Flows is at The NPV at The NPV reflects the increasing market value of equity.

Berlin, Fußzeile12 Opportunity Cost of Capital Example You may invest $100,000 today. Depending on the state of the economy, you may get one of three possible cash payoffs:

Berlin, Fußzeile13 Opportunity Cost of Capital Example - continued You know, the expected cash flow of ist uncertain. To calculate the NPV of your project you need the appropriate (risk adjusted) discount rate. How to get it ? You look at the market for risky investments – for example the stock market – and find a stock, trading for $ Next year’s stock price, given a normal economy, is forecasted at $110

Berlin, Fußzeile14 Opportunity Cost of Capital Example – continued The stocks expected payoff leads to the “expected return”.

Berlin, Fußzeile15 Opportunity Cost of Capital Example - continued Discounting the expected payoff at the expected rate of return of a comparable risky financial asset investment leads to the PV of the project