1. Instructor: Mr. Wajid Shakeel Ahmed
Last Study Topics
Opportunity Cost of Capital
Rate of an Alternative investment opportunity having a similar risk.
Investment vs. Consumption
Manager finds it difficult to reconcile the different objectives of the shareholders.
11/16/2014
Instructor: Mr. Wajid Shakeel Ahmed

2. Topics Covered Calculations of NPV & ROR
Managers and the Interests of Shareholders
Fundamental Study Result
Valuing Long-Lived Assets
PV Calculation Short Cuts

3. Calculation of NPV and ROR
The opportunity cost of capital is 20 percent for all four investments.
Initial Cash Cash Flow
Investment Flow, C0 in Year 1, C1
1 10, ,000
2 5, ,000
3 5, ,700
4 2, ,000
a. Which investment is most valuable?
b. Suppose each investment would require use of the same
parcel of land. Therefore you can take only one. Which one?
11/16/2014
Instructor: Mr. Wajid Shakeel Ahmed

4. Instructor: Mr. Wajid Shakeel Ahmed
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Instructor: Mr. Wajid Shakeel Ahmed

5. Instructor: Mr. Wajid Shakeel Ahmed
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Answer to question ‘a’;
Investment 1, since this investment with respect to others has generate highest NPV with Max rate of return.
Answer to question ‘b’;
Investment 1, since this investment with respect to others has highest contributed net value.
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Instructor: Mr. Wajid Shakeel Ahmed

6. Instructor: Mr. Wajid Shakeel Ahmed
Decision Rules
Here then we have two equivalent decision rules for capital investment;
Net present value rule; Accept investments that have positive net present values.
Rate-of-return rule; Accept investments that offer rates of return in excess of their opportunity costs of capital.
11/16/2014
Instructor: Mr. Wajid Shakeel Ahmed

7. Instructor: Mr. Wajid Shakeel Ahmed
Fundamental Result
Our justification of the present value rule was restricted to two periods and to a certain cash flow.
However, the rule also makes sense for uncertain cash flows that extend far into the future. The argument goes like this:
1- A financial manager should act in the interests of the firm’s owners, its stockholders.
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2- Stockholders do not need the financial manager’s help to achieve the best time pattern of consumption.
3- How then can the financial manager help the firm’s stockholders?
There is only one way: by increasing the market value of each stockholder’s stake in the firm.
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Despite the fact that shareholders have different preferences, they are unanimous in the amount that they want to invest in real assets.
This means that they can cooperate in the same enterprise and can safely delegate operation of that enterprise to professional managers.
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These managers do not need to know anything about the tastes of their shareholders and should not consult their own tastes.
Their task is to maximize net present value. If they succeed, they can rest assured that they have acted in the best interest of their shareholders.
11/16/2014
Instructor: Mr. Wajid Shakeel Ahmed

11. Managers and Shareholder Interests
Do managers really looking after the interests of shareholders?
This takes us back to the principal–agent problem.
Several institutional arrangements that help to ensure that the shareholders’ pockets are close to the managers’ heart.
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Instructor: Mr. Wajid Shakeel Ahmed

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Utilizing their Voting power;
If shareholders believe that the corporation is underperforming and that the board of directors is not sufficiently aggressive in holding the managers to task, they can try to replace the board in the next election.
E.g; chief executives of Eastman Kodak, General Motors, Xerox, Lucent, Ford Motor, etc were all forced to step aside.
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As a result the stock price tumbles.
This damages top management’s reputation and compensation.
Part of the top managers’ paychecks comes from bonuses tied to the company’s earnings or from stock options, which pay off if the stock price rises but are worthless if the price falls below a stated threshold.
This should motivate managers to increase earnings and the stock price.
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Instructor: Mr. Wajid Shakeel Ahmed

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If managers and directors do not maximize value, there is always the threat of a hostile takeover.
The further a company’s stock price falls, due to lax management or wrong-headed policies, the easier it is for another company or group of investors to buy up a majority of the shares.
The old management team is then likely to find themselves out on the street and their place is taken by a fresh team.
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Instructor: Mr. Wajid Shakeel Ahmed

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Should managers look after the interests of shareholders?
For this question we need to understand that In most instances there is little conflict between doing well (maximizing value) and doing good.
Profitable firms are those with satisfied customers and loyal employees and vice versa;
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Ethical issues do arise in business as in other walks of life.
when we say that the objective of the firm is to maximize shareholder wealth, we do not mean that anything goes.
In business and finance, as in other day-to-day affairs, there are unwritten, implicit rules of behavior.
To work efficiently together, we need to trust each other.
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Instructor: Mr. Wajid Shakeel Ahmed

17. The McGraw-Hill Companies, Inc., 2000
Principles of Corporate Finance
Brealey and Myers Sixth Edition
How to Calculate Present Values
Chapter 3
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Instructor: Mr. Wajid Shakeel Ahmed
Irwin/McGraw Hill
The McGraw-Hill Companies, Inc., 2000

18. Instructor: Mr. Wajid Shakeel Ahmed
Present Values
Discount Factor = DF = PV of $1
Discount Factors can be used to compute the present value of any cash flow.
11/16/2014
Instructor: Mr. Wajid Shakeel Ahmed

19. Instructor: Mr. Wajid Shakeel Ahmed
Present Values
Discount Factor = DF = PV of $1
Discount Factors can be used to compute the present value of any cash flow.
11/16/2014
Instructor: Mr. Wajid Shakeel Ahmed

20. Instructor: Mr. Wajid Shakeel Ahmed
Present Values
Discount Factors can be used to compute the present value of any cash flow.
11/16/2014
Instructor: Mr. Wajid Shakeel Ahmed

21. Instructor: Mr. Wajid Shakeel Ahmed
Present Values
Replacing “1” with “t” allows the formula to be used for cash flows that exist at any point in time.
11/16/2014
Instructor: Mr. Wajid Shakeel Ahmed

22. Instructor: Mr. Wajid Shakeel Ahmed
Present Values
Example
Suppose you will receive a certain cash inflow
of $100 next year (C1 = $100) and the rate of interest on one-year U.S. Treasury notes is 7 percent (r1 = 0.07). What would be the present value of Cash inflow ?
11/16/2014
Instructor: Mr. Wajid Shakeel Ahmed

23. Instructor: Mr. Wajid Shakeel Ahmed
Present Values
Example
Suppose you will receive a certain cash inflow
of $100 in two year (C2 = $100) and the rate of interest on two-year U.S. Treasury notes is 7.7 percent (r1 = 0.077). What would be the present value of year 2 Cash inflow ?
11/16/2014
Instructor: Mr. Wajid Shakeel Ahmed

24. Instructor: Mr. Wajid Shakeel Ahmed
Present Values
Example
You just bought a new computer for $3,000. The payment terms are 2 years same as cash. If you can earn 8% on your money, how much money should you set aside today in order to make the payment when due in two years?
11/16/2014
Instructor: Mr. Wajid Shakeel Ahmed

25. Instructor: Mr. Wajid Shakeel Ahmed
Present Values
Example
You just bought a new computer for $3,000. The payment terms are 2 years same as cash. If you can earn 8% on your money, how much money should you set aside today in order to make the payment when due in two years?
11/16/2014
Instructor: Mr. Wajid Shakeel Ahmed

26. Instructor: Mr. Wajid Shakeel Ahmed
Present Values
PVs can be added together to evaluate multiple cash flows.
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Instructor: Mr. Wajid Shakeel Ahmed

27. Instructor: Mr. Wajid Shakeel Ahmed
Present Values
PVs can be added together to evaluate multiple cash flows, and called as discounted cash flow or (DCF) formula;
11/16/2014
Instructor: Mr. Wajid Shakeel Ahmed

28. Instructor: Mr. Wajid Shakeel Ahmed
Present Values
If a dollar tomorrow is worth less than a dollar today, one might suspect that a dollar the day after tomorrow should be worth even less.
But, lets assume - given two dollars, one received a year from now and the other two years from now, the value of each is commonly called the Discount Factor. Assume r1 = 20% and r2 = 7%.
11/16/2014
Instructor: Mr. Wajid Shakeel Ahmed

29. Instructor: Mr. Wajid Shakeel Ahmed
Present Values
Given two dollars, one received a year from now and the other two years from now, the value of each is commonly called the Discount Factor. Assume r1 = 20% and r2 = 7%.
11/16/2014
Instructor: Mr. Wajid Shakeel Ahmed

30. Instructor: Mr. Wajid Shakeel Ahmed
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If First we lend $1,000 for one year at 20 percent, we have;
FV = PV (1+rt)t =
Go to the bank and borrow the present value of this $1,200 at 7 percent interest, we have;
PV = FV / (1+rt)t
11/16/2014
Instructor: Mr. Wajid Shakeel Ahmed

31. Instructor: Mr. Wajid Shakeel Ahmed
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If we going to find out the net present value of our investment we get,
NPV = PV – Investment
= $ $1200
“Just imagine in this game of lending and borrowing
How much money you can earn without taking risks”
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Instructor: Mr. Wajid Shakeel Ahmed

32. Instructor: Mr. Wajid Shakeel Ahmed
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Of course this story is completely fanciful.
“There is no such thing as a money machine.”
In well-functioning capital markets, any potential money machine will be eliminated almost instantaneously by investors who try to take advantage of it.
11/16/2014
Instructor: Mr. Wajid Shakeel Ahmed

33. Instructor: Mr. Wajid Shakeel Ahmed
Present Values
Example
Assume that the cash flows from the construction and sale of an office building is as follows. Given a 7% required rate of return, create a present value worksheet and show the net present value.
11/16/2014
Instructor: Mr. Wajid Shakeel Ahmed

34. Instructor: Mr. Wajid Shakeel Ahmed
Present Values
Example - continued
Assume that the cash flows from the construction and sale of an office building is as follows. Given a 7% required rate of return, create a present value worksheet and show the net present value.
11/16/2014
Instructor: Mr. Wajid Shakeel Ahmed

35. Instructor: Mr. Wajid Shakeel Ahmed
NPV Formula
Mathematically; 7%
∑PV = PV of C1+ PV of C2
= -$93,500 + $261,900
= $168,400
NPV = ∑ PV - INV
= $168,400 - $150,000
= $18,400
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Instructor: Mr. Wajid Shakeel Ahmed

36. Summary Calculations of NPV & ROR
Managers and the Interests of Shareholders
Fundamental Study Result
Valuing Long-Lived Assets

37. Instructor: Mr. Wajid Shakeel Ahmed
Short Cuts
Sometimes there are shortcuts that make it very easy to calculate the present value of an asset that pays off in different periods.
These tolls allow us to cut through the calculations quickly.
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Instructor: Mr. Wajid Shakeel Ahmed

38. Instructor: Mr. Wajid Shakeel Ahmed
Short Cuts
Perpetuity - Financial concept in which a cash flow is theoretically received forever.
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Instructor: Mr. Wajid Shakeel Ahmed

39. Instructor: Mr. Wajid Shakeel Ahmed
Short Cuts
Perpetuity - Financial concept in which a cash flow is theoretically received forever.
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Instructor: Mr. Wajid Shakeel Ahmed

40. Instructor: Mr. Wajid Shakeel Ahmed
Case : Investment A
An investment costs $1,548 and pays $138 in perpetuity. If the interest rate is 9 percent, what is the NPV?
PV = C / r
= $
NPV = PV - INV
= $ $1548
= -$ 14.67
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Instructor: Mr. Wajid Shakeel Ahmed

41. Instructor: Mr. Wajid Shakeel Ahmed
Short Cuts
Annuity - An asset that pays a fixed sum each year for a specified number of years.
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Instructor: Mr. Wajid Shakeel Ahmed

42. Instructor: Mr. Wajid Shakeel Ahmed
Case: leasing a car
Example
You agree to lease a car for 4 years at $300 per month. You are not required to pay any money up front or at the end of your agreement. If your opportunity cost of capital is 0.5% per month, what is the cost of the lease?
11/16/2014
Instructor: Mr. Wajid Shakeel Ahmed

43. Instructor: Mr. Wajid Shakeel Ahmed
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Example - continued
You agree to lease a car for 4 years at $300 per month. You are not required to pay any money up front or at the end of your agreement. If your opportunity cost of capital is 0.5% per month, what is the cost of the lease?
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Instructor: Mr. Wajid Shakeel Ahmed

44. Instructor: Mr. Wajid Shakeel Ahmed
Case: Endowment Funds
Example - Suppose, for example, that we begins to wonders what it would cost to contribute in a endowment fund with an amount of $100,000 a year for only 20 years?
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Instructor: Mr. Wajid Shakeel Ahmed

45. Instructor: Mr. Wajid Shakeel Ahmed
Alternatively
We can simply look up the answer in the annuity table given on the next slide.
This table gives the present value of a dollar to be received in each of t periods.
In our example t = 20 and the interest rate r = .10, and therefore;
We look at the twentieth number from the top in the 10 percent column. It is Multiply by $100,000, and we have our answer,
$851,400.
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Instructor: Mr. Wajid Shakeel Ahmed

46. Instructor: Mr. Wajid Shakeel Ahmed
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Instructor: Mr. Wajid Shakeel Ahmed

47. Instructor: Mr. Wajid Shakeel Ahmed
Compound Interest
There is an important distinction between compound interest and simple interest.
When money is invested at compound interest, each interest payment is reinvested to earn more interest in subsequent periods.
In contrast, the opportunity to earn interest on interest is not provided by an investment that pays only simple interest.
11/16/2014
Instructor: Mr. Wajid Shakeel Ahmed