1. Chapter 2 Principles of Corporate Finance Eighth Edition Present Value, the Objectives of The Firm, and Corporate Governance Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

2. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 2 McGraw-Hill/Irwin Topics Covered  Introduction to Present Value  Foundations of the Net Present Value Rule  Corporate Goals and Corporate Governance

3. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 3 McGraw-Hill/Irwin Present and Future Value Present Value Value today of a future cash flow. Future Value Amount to which an investment will grow after earning interest

4. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 4 McGraw-Hill/Irwin 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. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 5 McGraw-Hill/Irwin Future Values Future Value of $100 = FV

6. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 6 McGraw-Hill/Irwin Future Values Example - FV What is the future value of $5400,000 if interest is compounded annually at a rate of 5% for one year?

7. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 7 McGraw-Hill/Irwin Present Value

8. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 8 McGraw-Hill/Irwin Present Value Discount Factor = DF = PV of $1 Discount Factors can be used to compute the present value of any cash flow.

9. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 9 McGraw-Hill/Irwin Valuing an Office Building Step 1: Forecast cash flows Cost of building = C 0 = 400 Sale price in Year 1 = C 1 = 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%

10. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 10 McGraw-Hill/Irwin Valuing an Office Building Step 3: Discount future cash flows Step 4: Go ahead if PV of payoff exceeds investment

11. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 11 McGraw-Hill/Irwin Net Present Value

12. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 12 McGraw-Hill/Irwin Risk and Present Value  Higher risk projects require a higher rate of return  Higher required rates of return cause lower PVs

13. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 13 McGraw-Hill/Irwin Risk and Present Value

14. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 14 McGraw-Hill/Irwin Risk and Net Present Value

15. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 15 McGraw-Hill/Irwin 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?

16. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 16 McGraw-Hill/Irwin 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?

17. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 17 McGraw-Hill/Irwin 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:

18. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 18 McGraw-Hill/Irwin Opportunity Cost of Capital Example - continued The stock is trading for $95.65. Next year’s price, given a normal economy, is forecast at $110 The stocks expected payoff leads to an expected return.

19. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 19 McGraw-Hill/Irwin Opportunity Cost of Capital Example - continued Discounting the expected payoff at the expected return leads to the PV of the project

20. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 20 McGraw-Hill/Irwin 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.

21. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 21 McGraw-Hill/Irwin 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.

22. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 22 McGraw-Hill/Irwin Investment vs. Consumption A n B n 100 80 60 40 20  406080100 income in period 0 income in period 1 Some investors will prefer A and others B

23. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 23 McGraw-Hill/Irwin 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.

24. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 24 McGraw-Hill/Irwin 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. 185 200 Dollars Now Dollars Next Year 210 194 A invests $185 now and consumes $210 next year G invests $185 now, borrows $200 and consumes now.

25. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 25 McGraw-Hill/Irwin 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

26. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 26 McGraw-Hill/Irwin Whose Company Is It? ** Survey of 378 managers from 5 countries

27. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 27 McGraw-Hill/Irwin Dividends vs. Jobs ** Survey of 399 managers from 5 countries. Which is more important...jobs or paying dividends?

28. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 28 McGraw-Hill/Irwin 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

29. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 29 McGraw-Hill/Irwin Goals of The Corporation Agency Problem Solutions 1 - Compensation plans 2 - Board of Directors 3 - Takeovers 4 - Specialist Monitoring 5 - Auditors

30. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 30 McGraw-Hill/Irwin Web Resources www.smartmoney.com www.moneychimp.com/features/rule72.htm www.mhhe.com/business/finance/corpfinonline www.bankrate.com/brm/default.asp www.financenter.com Click to access web sites Internet connection required