1. Present Value, The Objectives of The Firm, and Corporate Governance
Chapter 2
Principles of
Corporate
Finance
Ninth Edition
Present Value, The Objectives of The Firm, and Corporate Governance
Slides by
Matthew Will
McGraw Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved

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

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

4. Discount Factors and Rates
Discount Rate
Interest rate used to compute present values of future cash flows.
Discount Factor
Present value of a $1 future payment.

5. Future Values
Future Value of $100 = FV 21

6. Future Values Example - FV
What is the future value of $100 if interest is compounded annually at a rate of 6% for five years? 23

7. Future Values Example - FV
What is the future value of $400,000 if interest is compounded annually at a rate of 5% for one year? 23

8. Present Value

9. Present Value Discount Factor = DF = PV of $1
Discount Factors can be used to compute the present value of any cash flow.

10. Valuing an Office Building
Step 1: Forecast cash flows
Cost of building = C0 = 400,000
Sale price in Year 1 = C1 = 420,000
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%

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

12. Net Present Value

13. Risk and Present Value
Higher risk projects require a higher rate of return
Higher required rates of return cause lower PVs

14. Risk and Present Value

15. Risk and Net Present Value

16. 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?

17. 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?

18. 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:

19. Opportunity Cost of Capital
Example - continued
The stock is trading for $ Next year’s price, given a normal economy, is forecast at $110
The stocks expected payoff leads to an expected return.

20. Opportunity Cost of Capital
Example - continued
Discounting the expected payoff at the expected return leads to the PV of the project
NPV requires the subtraction of the initial investment

21. 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.

22. 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 firm’s shareholders.

23. Investment vs. Consumption
A n
B n
100 80 60 40 20
income in period 0
income in period 1
Some investors will prefer A
and others B

24. Investment vs. Consumption
The grasshopper (G) wants to consume now. The ant (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.

25. Investment vs. Consumption
The grasshopper (G) wants to consume now. The ant (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.
A invests $185 now and consumes $210 next year
Dollars Next Year
210
194
G invests $185 now, borrows $200 and consumes now.
Dollars Now

26. Managers and Shareholder Interests
Tools to Ensure Management Pays Attention to the Value of the Firm
Manger’s 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

27. Whose Company Is It?
** Survey of 378 managers from 5 countries

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

29. 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 17

30. Goals of The Corporation
Agency Problem Solutions
1 - Compensation plans
2 - Board of Directors
3 - Takeovers
4 - Specialist Monitoring
5 - Auditors 18

31. Web Resources Web Links Click to access web sites
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