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Chapter 2 Principles of

Corporate Finance, 8/e(Special Indian Edition)

Present Values, the

Objectives of the

Firm, and Corporate

Governance

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Topics Covered

Introduction to Present ValueFoundations of the Net Present Value

Rule

Corporate Goals and CorporateGovernance

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Present and Future Value

Present Value

Value today of a

future cashflow.

Future Value

Amount to which an

investment will grow

after earning interest

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Discount Factors and Rates

Discount Rate

Interest rate used

to compute

present values of future cash flows. Discount Factor

Present value of

a Rs.1 futurepayment.

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Future Values

Future Value of Rs.100 = FV

.100 (1 )t FV Rs r

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Future Values

.100 (1 )t FV Rs r

Example - FV

What is the future value of Rs.400,000 if interest is

compounded annually at a rate of 5% for one year?

1.400,000 (1 .05) .420,000FV Rs Rs

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Present Value

1factordiscount=PV

PV=ValuePresent

C

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Present Value

Discount Factor = DF = PV of Rs.1

Discount Factors can be used to compute the present value of

any cash flow.

DF r t

1

1( )

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Valuing an Office Building

Step 1: Forecast cash flows Cost of building = C0 = 400

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%

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Valuing an Office Building

Step 3: Discount future cash flows

Step 4: Go ahead if PV of payoff exceeds investment

400)05.1(

420

)1(

1

r

C PV

30370400 NPV

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Net Present Value

r

C

1

C=NPV

investmentrequired-PV=NPV

10

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Risk and Present Value

Higher risk projects require a higher rate of return

Higher required rates of return cause lower

PVs

1PV of C Rs.420 at 5%

420PV 400

1 .05

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Risk and Present Value


420PV 400

1 .05


420PV 375

1 .12

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Risk and Net Present Value

NPV=PV-required investment

NPV=375,000-370,000

Rs.5,000

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Rate of Return Rule

Accept investments that offer rates of returnin excess of their opportunity cost of capital

Example

In the project listed below, the foregone investment

opportunity is 12%. Should we do the project?

13.5%or.135370,000

370,000420,000

investment

profitReturn

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Net Present Value Rule

Accept investments that have positive netpresent value

ExampleSuppose we can invest Rs.50 today and receive

Rs.60 in one year. Should we accept the project

given a 10% expected return?

60NPV=-50+ .4.55

1.10 Rs

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Opportunity Cost of Capital

Example You may invest Rs.100,000 today. Depending on

the state of the economy, you may get one of three

possible cash payoffs:

Economy Slump Normal Boom

Payoff Rs.80,000 110,000 140,000

1

80,000 110,000 140,000Expected payoff C .110,000

3 Rs

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Example - continued The stock is trading for Rs.95.65. Next year’s

price, given a normal economy, is forecast at

Rs.110

The stocks expected payoff leads to an expected

return.

15%or15.65.95

65.95110profitexpected

returnExpected

investment

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Example - continued Discounting the expected payoff at the expected

return leads to the PV of the project

110,000

PV .95,6501.15 Rs

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Example - continued Notice that you come to the same conclusion if you

compare the expected project return with the cost

of capital.

10%or10.000,100

000,100000,110profitexpectedreturnExpected

investment

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Investment vs. Consumption

A n

B n

100

80

60

40

20

20 40 60 80 100income in period 0

income in period 1

Some investors will prefer A

and others B

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The grasshopper (G) wants to

consume now. The ant (A) wants to

wait. But each is happy to invest.

Each invests Rs.185,000 and returns

Rs.210,000 at the end of the year. Gwants to consume now so G borrows

Rs.200,000 and repays Rs.210,000 at

the end of the year. The existence of

capital markets allows G to consumenow and still invest with A in the

project.

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The grasshopper (G) wants to consume

now. The ant (A) wants to wait. Buteach is happy to invest. Each invests

Rs.185,000 and returns Rs.210,000 at the

end of the year. G wants to consume now

so G borrows Rs.200,000 and repays

Rs.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 200Rupees

Now

Rupees

Next Year

210

194

A invests Rs.185 now

and consumes Rs.210

next year

G invests Rs.185 now,

borrows Rs.200 and

consumes now.

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Managers and Shareholder Interests

Tools to Ensure Management PaysAttention 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

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Whose Company Is It?

24

29

78

83

97

76

71

22

17

3

0 20 40 60 80 100 120

United States

United Kingdom

France

Germany

Japan

% of responsesThe Shareholders

All Stakeholders

** Survey of 378 managers from 5 countries

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Dividends vs. Jobs

11

11

59

60

97

89

89

41

40

3

0 20 40 60 80 100 120

United States

United Kingdom

France

Germany

Japan

% of responsesDividends

Job Security

** Survey of 399 managers from 5 countries. Which is more important...jobs or

paying dividends?

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Goals of The Corporation

Shareholders desire wealthmaximization

Do managers maximize shareholder

wealth?Mangers have many constituencies

“stakeholders”

“Agency Problems” represent theconflict of interest between

management and owners

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Goals of The Corporation

Agency Problem Solutions1 - Compensation plans

2 - Board of Directors

3 - Takeovers

4 - Specialist Monitoring

5 - Auditors

1- 30Corporate Governance Problem in

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1 30Corporate Governance Problem in

India

Prof. J R Varma of IIM Ahmedabad has observedthat the corporate governance problem in India is

completely different from that of the Anglo-

American system. In India, there is a conflict of

interest between the promoter shareholders (whomostly control the management) and the public

shareholders. So it would be foolish to expect the

Board in India to discipline the shareholders from

whom it derives all its powers

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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

http://www.smartmoney.com/

http://www.moneychimp.com/features/rule72.htm

http://www.mhhe.com/business/finance/corpfinonline

http://www.bankrate.com/brm/default.asp

http://www.financenter.com/

http://www.financenter.com/

http://www.bankrate.com/brm/default.asp

http://www.mhhe.com/business/finance/corpfinonline

http://www.moneychimp.com/features/rule72.htm

http://www.smartmoney.com/

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