presentvalueandtheopportunitycostofcapital.pptVIP

Slides by Matthew Will Topics Covered Present Value Net Present Value NPV Rule ROR Rule Opportunity Cost of Capital Managers and the Interests of Shareholders Present Value Present Value Present Value Valuing an Office Building Step 1: Forecast cash flows Cost of building = C0 = 350 Sale price in Year 1 = C1 = 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% Valuing an Office Building Step 3: Discount future cash flows Step 4: Go ahead if PV of payoff exceeds investment Net Present Value Risk and Present Value Higher risk projects require a higher rate of return Higher required rates of return cause lower PVs Risk and Present Value Rate of Return Rule Accept investments that offer rates of return in excess of their opportunity cost of capital Rate of Return Rule Accept investments that offer rates of return in excess of their opportunity cost of capital Net Present Value Rule Accept investments that have positive net present value Net Present Value Rule Accept investments that have positive net present value 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: 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 Opportunity Cost of Capital Example - continued The stocks expected payoff leads to an expected return. Opportunity Cost of Capital Example - continued Discounting the expected payoff at the expected return leads to the PV of the project 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. Investment vs. Consumption Investment vs. Consumption The grasshopper (G) want