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The Capital Budgeting Decision

Ninth edition

Individuals and businesses face large numbers of decisions where it is feasible to


quantify key costs and benefits of a long-lived project. This invaluable book enables the
decision-maker to make informed choices presented with elements of time and risk.
While other measures can help describe the outcomes, Bierman and Smidts book
focuses on the theme of net present value (NPV) how it is the most reliable single
measure of value, and how it is important for those making investment decisions to
understand the limitations of the different calculations.
Here in its ninth edition, this classic text returns to its roots as a clear and concise
introduction to this complex but essential topic in corporate finance. An expanded theme
of this edition is adjusting for uncertainty, and a wholly new chapter exploring the use
of real options has been added. Retaining the authority and reputation of previous
editions, it now covers in depth several topics which are under-explored by the competition,
including:

distribution policy and capital budgeting;


a firm investing in a second firm;
investing in current assets.

Easily understandable, and covering the essentials of capital budgeting, this book will help
readers to make intelligent capital budgeting decisions for corporations of every type.
Harold Bierman, Jr. is the Nicholas H. Noyes Professor of Business Administration at
the Johnson Graduate School of Management, Cornell University.
Seymour Smidt is Professor Emeritus at the Johnson Graduate School of Management,
Cornell University.

The Capital
Budgeting
Decision
Economic analysis of
investment projects
Ninth edition
Harold Bierman, Jr. and
Seymour Smidt

First edition published by Macmillan in 1960


2nd edition, 1966
3rd edition, 1970
4th edition, 1975
5th edition, 1980
6th edition, 1984
7th edition, 1988
8th edition, 1992
9th edition published 2007
by Routledge
711 Third Avenue, New York NY 10017
Simultaneously published in Great Britain
by Routledge
2 Park Square, Milton Park, Abingdon, Oxon, OX14 4RN
Routledge is an imprint of the Taylor & Francis Group, an informa business
Transferred to Digital Printing 2007
1960, 1966, 1970, 1975, 1980, 1984, 1988, 1992, 2007 Harold Bierman, Jr.
and Seymour Smidt
Typeset in Perpetua and Bell Gothic by
Newgen Imaging Systems (P) Ltd, Chennai, India
All rights reserved. No part of this book may be reprinted or reproduced or utilised in
any form or by any electronic, mechanical, or other means, now known or hereafter
invented, including photocopying and recording, or in any information storage or
retrieval system, without permission in writing from the publishers.
Library of Congress Cataloging in Publication Data
Bierman, Harold.
The capital budgeting decision: economic analysis of investment projects /
Harold Bierman and Seymour Smidt. [Rev. ed.]
p. cm.
Includes bibliographical references and index.
ISBN 0415400031 ISBN 041540004X (soft cover) 1. Capital
investmentsEvaluation. 2. Capital budget. I. Smidt, Seymour. II.Title.
HG4028.C4B54 2006
658.152 dc22
2006019300
British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library
ISBN10: 0415400031 (hbk)
ISBN10: 041540004X (pbk)

ISBN13: 9780415400039 (hbk)


ISBN13: 9780415400046 (pbk)

Contents

List of illustrations
Preface
Extracts from the preface to the first edition

xiii
xvii
xix

1 INVESTMENT DECISIONS AND CORPORATE OBJECTIVES


Investment decisions
The limitations of quantification
The state of business practice
Time, risk, and the riskreturn trade-off
Three basic generalizations
Relevance of cash flows
Cash flows versus earnings
The capital market
The weighted average cost of capital
Tactical and strategic decisions
The role of strategic planning
The two capital budgeting revolutions
Conclusions
Pop quiz
Problems
Answer to pop quiz
Bibliography

1
2
3
4
4
4
5
6
6
7
7
8
8
9
10
10
11
11

2 THE TIME VALUE OF MONEY


Time discounting
Future value
Present value
Computing present value factors
Annual equivalent amounts
A growing annuity
A constant interest bond
Present value factors derived from market prices
Conclusions

12
12
13
15
16
23
24
25
26
31

CONTENTS
Pop quiz
Review problem
Problems
Answer to pop quiz
Solution to review problem
Bibliography
Appendix A
Appendix B
3 CAPITAL BUDGETING: THE TRADITIONAL SOLUTIONS
A capital budgeting decision
Rate of discount
Classification of cash flows
Classifying investments
Measures of investment worth
Two discounted cash flow methods
Net present value profile
Payback period
Return on investment
What firms do
Cash flows
Working capital
Excluding interest payment
Conclusions
Pop quiz
Review problems
Problems
Answers to pop quiz
Solutions to review problems
Bibliography
4 MUTUALLY EXCLUSIVE INVESTMENTS
Accept or reject decisions
Mutually exclusive investment
Incremental benefits: the scale problem
Timing
Reinvestment assumption
Reinvestment rate of return
Loan-type flows
Multiple internal rates of return
Interpretation of multiple IRRs
A paradox
Converting multiple IRRs to a single IRR
Significance of nonconventional cash flows
Ranking independent investments
Mutually exclusive alternatives with different risks
Duration: a sensitivity measure
Why the internal rate of return method is popular
Choosing the required rate of return
Conclusions

vi

32
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35
36
36
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37
43
43
43
44
44
46
48
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54
55
60
61
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83
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87
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88
91
91
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94
95
97
99
100
101
102
103
103
104

CONTENTS
Review problem
Problems
Solution to review problem
Bibliography

105
106
111
112

ANNUAL EQUIVALENT COSTS AND REPLACEMENT DECISIONS


Annual equivalent cost
Make or buy decisions
Comparability
Mutually exclusive alternatives with different lives
Annual equivalent cost
Lowest common multiple life
A perpetuity
Components of unequal lives
Cost of excess capacity
The equal cost assumption
The replacement decision
Replacement chains
Conclusions
Review problem
Problems
Solution to review problem
Bibliography

113
113
114
116
116
118
119
119
120
121
122
122
125
125
126
127
133
134

CAPITAL BUDGETING UNDER CAPITAL RATIONING


External capital rationing
Internal capital rationing
Internal capital rationing and dividend policy
Ranking of investments
Index of present value (or profitability index)
Programming solutions
Capital rationing and risk
Conclusions
Problems
Bibliography

135
136
141
141
142
144
145
148
148
148
150

THE USE OF THE WEIGHTED AVERAGE COST OF CAPITAL


AND OTHER RATES OF DISCOUNT
The sources of cash
The cost of retained earnings
A theory of stock values
Changes in stock prices
Accumulated depreciation and the cost of capital
Issuing common stock
Cost of retained earnings: with investor taxes
Cost of new equity capital
Issuing common stock: the element of timing
Delaying the investment
Cost of long-term debt
Cost of short-term debt

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153
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154
157
158
160
160
161
161
163
164
165

vii

CONTENTS
Debt and income taxes
Weighted average cost of capital
The optimum capital structure
Summary of weighted average cost of capital
Default-free rate of discount
Adjusting the default-free rate
Comparing average and marginal returns
Conclusions
Problems
Bibliography

166
167
168
169
170
171
172
172
172
178

8 THE CAPITAL ASSET PRICING MODEL


The assumptions
Introduction to portfolio analysis
Forming portfolios
The investors
Portfolio analysis with a riskless security
The efficient frontier
The capital market line
The expected rate of return of a security
The security characteristic line
Systematic and unsystematic risks
The security market line
Required rate of return versus WACC
Making investment decisions
Conclusions
Review problem
Problems
Solution to review problem
Bibliography

180
181
182
183
186
187
187
190
192
192
194
195
197
198
199
200
201
204
204

9 THE COST OF CAPITAL AND CAPITAL STRUCTURE


The weighted average cost of capital
Definition
The weights
Capital budgeting decisions
Investments and taxes
Existence of a unique optimal financial structure
No taxes
A constant WACC (no taxes)
A constant value
Levering a firm
Taxes
Implications of the zero corporate tax model
The value of a levered firm with taxes
Valuing a firm: capital structure and corporate taxes
Personal taxes
Conclusions
Problems
Bibliography

206
206
207
209
210
210
211
213
216
217
217
218
219
219
220
221
222
224
229

viii

CONTENTS
10 DISTRIBUTION POLICY AND CAPITAL BUDGETING
A cash dividend: from retained earnings
Investment: new capital
Share repurchase versus real investment
A different required return
Model
Maintenance cap-ex
The capital structure
Risk assumptions
The derivation of 1/(M1)
Conclusions
Problems
Bibliography

231
231
232
233
234
234
236
236
236
237
240
240
241

11 A FIRM INVESTING IN A SECOND FIRM


Tax implications
Anti-raiding maneuver
Antitrust considerations
An acquisition for cash
Determining the premium
Analysis with capital gains
A holding company
Valuation for acquisition
The P/E ratio
Dilution of earnings: the period of dilution
Elimination of dilution
Forecasting the post-acquisition price
Dividend versus an acquisition of shares
Conclusions
Problems
Bibliography

242
243
244
244
244
245
247
249
249
251
254
254
256
257
259
259
261

12 INVESTING IN CURRENT ASSETS


Decisions affecting cash
Timing strategies
Acquiring the cash from long-term sources
A reformulation
Timing considerations
Near-cash securities
Managing accounts receivable
Calculation of costs
One-period case with time discounting
Multiperiod case
Systematic revision of probabilities
Problems in application
Inventory and finance
Inventory models versus just in time
Inventory models
Conclusions
Problems
Bibliography

262
263
264
266
268
271
271
273
275
275
277
278
280
281
282
282
285
287
289

ix

CONTENTS
13 FOREIGN INVESTMENTS
Currency translation
A different approach
The irrelevance of future plans
The leverage consideration
Taxes
One-period example
Multiperiod case
Remission of funds
Foreign investment and risk
Conclusions
Problems
Bibliography

290
290
291
292
293
295
295
296
297
297
298
298
301

14 THE BUY VERSUS LEASE DECISION


Three basic problems of analysis
One incorrect method
The two correct methods
Residual value
The investment decision
The lease decision with taxes
Risk-adjusted discount rates
The calculation that is not made
Cash flows and discount rate: debt
Pros and cons of leasing
Three decisions
Conclusions
Problems
Bibliography

303
303
304
306
306
307
309
311
311
312
313
315
316
316
318

15 AN INTRODUCTION TO REAL OPTIONS


BlackScholes
Option valuation when there is no hedge portfolio
The value of waiting
An option to expand
Put options on real assets: an opportunity to sell
Embedded options: the value of future uses
Valuation: expected value less than liabilities
Advantages of the option approach
Disadvantages of the option approach
Conclusions
Problems
Discussion question
Bibliography

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320
321
323
324
326
327
327
328
329
330
331
332
332

16 CAPITAL BUDGETING AND INFLATION


What is inflation?
Real cash flows
Real cash flows and nominal flows

334
334
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335

CONTENTS
The use of specific prices
Real and nominal discount rates
Inflation analysis: a simplified approach
Tax effects
A tax-exempt alternative
The real return and the rate of inflation
Conclusions
Problems
Bibliography

336
338
340
342
343
343
346
346
348

17 REFLECTIONS ON THE CAPITAL BUDGETING DECISION


The criticisms of NPV
Cash on cash
Real options
Cash flow components
The compounding of risk
Investing in other countries
Conclusions
Problems

350
350
351
352
353
353
353
354
354

18 CASES

356

APPENDICES
Table A: Present value of $1.00
Table B: Present value of $1.00 received per period

380
380
384

Name index
Subject index

389
393

xi

Illustrations

FIGURES
2.1
3.1
3.2
3.3
4.1
4.2
4.3
4.4
4.5
4.6
4.7
6.1
6.2
8.1
8.2
8.3
8.4
8.5
8.6
8.7
8.8
8.9
8.10
9.1
9.2
9.3
9.4
12.1
12.2
12.3
12.4

A spot rate curve


Investment relationships
Net present value profile
Net present value profile of a loan
Net present value profile
Two mutually exclusive investments, A and B
Two mutually exclusive investments, Y and Z
Loan-type flows
An incremental investment with multiple rates of return
Multiple rates of return
Effect of discount rate on investment choice
Investment opportunities
Two independent investments
Perfect linear dependence of rates of return (r1and r2)
of two securities, A and B
Perfect negative correlation
Two securities A and B and different values of 
Two investment indifference curves
Choosing portfolios
The capital market line and the efficient frontier
The capital market line
The security characteristic line
The security market line
A firm with a weighted average cost of capital (WACC) of 0.15
A constant weighted average cost of capital (k0)
The classical view of an optimum capital structure
Costs of capital (with constant costs of debt)
ki curve
Issue long-term debt to replace short-term debt
Issue long-term debt to acquire short-term assets
A mixed strategy
Two cash strategies

28
46
53
54
86
89
90
93
94
95
101
138
143
184
185
185
187
187
188
191
193
196
197
212
213
215
226
265
265
266
266

xiii

ILLUSTRATIONS
12.5
12.6
12.7
12.8
12.9
13.1
13.2
13.3
15.1
15.2
18.1

Optimum bond issue size


Amount of idle cash
Tree diagram for credit decision
A two-period credit decision
A three-period credit decision
The basic investment
Stock equity cash flows (yen)
Investment example
Can delay the $60,000 outlay
Value of stock with two outcomes
Simplified decision tree for the alternative

268
269
274
277
279
293
294
300
324
328
376

TABLES
2.1
3.1
3.2
3.3
3.4
3.5
3.6
3.7

Time until doubling


Definition of conventional and non-conventional investments
Example of cash flows from an investment
Computation of NPV using a 0.10 discount rate
Computation of NPV using a 0.20 discount rate
Computation of NPV using the IRR of 0.16 as the discount rate
ROIs of two investments financed with stock
Net present values for five different lives for an investment generating
$10,000 per year for four years
What firms do: a survey in 1992
Percentage of firms using method
Net cash flow calculation (stock equity flows)
Depreciation methods
Depreciation rates for 3, 5, 7, 10, 15, and 20 year property classes
Depreciation rates: residential rental property straight line
27.5 years, for property placed in service in July
Depreciation rates: nonresidential real property straight
line 39 years, for property placed in service in July
Computation of income tax
Computation of cash flows
Computation of the present value of cash flows
Cash flow examples
New product information (1)
New product information (2)
Two mutually exclusive investments, A and B
Cash flows for two investments, Y and Z
Investment Y minus Z
Cash flows for two mutually exclusive investments
Two investments with different rankings
Make or buy decisions
Present value calculation
Annual equivalent cost
Asset replacement decision
Asset replacement cash flow

3.8
3.9
3.10
3.11
3.12
3.13
3.14
3.15
3.16
3.17
3.18
3.19
3.20
4.1
4.2
4.3
4.4
4.5
5.1
5.2
5.3
5.4
5.5

xiv

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44
50
50
52
52
56
59
60
60
65
70
70
71
71
72
72
73
79
80
81
88
89
89
93
100
114
115
115
123
124

ILLUSTRATIONS
7.1
7.2
8.1
9.1
11.1
11.2
11.3
12.1
12.2
12.3
12.4
16.1
16.2
16.3
16.4
16.5
16.6
16.7

18.1
18.2
A
B

Illustrative calculation of after-tax weighted average cost


Balance sheet
Summary of graphed information
Estimate of the cost of capital (WACC)
Financial information for two firms and for their combination
Additional information
Financial data for two firms
Three possible outcomes and their probabilities
Expected value of offering credit
Probability of demand
Order four units
Examples of effects of price level and labor expense changes
on nominal and real cash flows
Nominal discount rate and present value
Converting nominal cash flows to real cash flows
Converting real cash flows to nominal cash flows
Projected nominal cash flows
Projected nominal cash flows reflecting expected price deflation
Nominal interest rates consistent with various expected rates of
inflation and marginal tax brackets, assuming a 3 percent
before-tax real return for marginal tax investors
Capital budget analysis, $10 million investment
Weighted average cost of capital (WACC)
Present value of $1.00 (1  r)n
Present value of $1.00 received per period (1  (1  r)n) / r

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251
252
255
278
280
284
284
337
339
339
340
341
341

346
359
365
380
384

xv

Preface

Their MBAs came in and said, Give us your five-year plan.


Our Long-range plan was where wed have lunch tomorrow.
Laurie P. Cohen (former head of an office-equipment
company controlled by Exxon), The Wall Street Journal,
Monday, September 10, 1984

This edition follows the direction of its predecessor. When the first edition was
published in 1960, we were convinced that the net present value method was superior to other methods of making investment decisions.We still believe this. In the
important area of uncertainty, however, our attitudes have undergone some
changes that were first incorporated in the second edition. The greatest changes
from the first edition will be found in the general method of incorporating
uncertainty in the investment decision process.
We continue to advocate the net present value method. In practice, most
projects are analyzed using an estimate of the expected cash flows. A risk
adjustment is necessary. The risk adjustment should reflect all of the strategic
aspects of the project.The most common procedure for coping with risk is to use
a risk-adjusted discount rate.
It may not be appropriate to require all projects to earn a rate equal to the firms
weighted average cost of capital. Some investments with internal rates of return
less than the firms weighted average cost of capital (WACC) may be acceptable,
and some investment with an internal rate of return greater than the firms WACC
should be rejected.The average cost of capital is a useful concept in handling capital structure questions, but it is less reliable in evaluating investment alternatives.
However, it is relatively simple to apply; thus, it is widely used in investment analysis. But basing a decision on the discounting of expected cash flows using the firms
WACC might not always lead to the decision that is best from the viewpoint of
either management or shareholders. Since most projects consist of a mixture of
cash flow components with different risks, it may be appropriate to use a different
discount rate for each cash flow component.

xvii

PREFACE

The basic capital budgeting material is in the first six chapters. Chapters 7 and 8
deal with various aspects of capital budgeting under uncertainty. Some of the
material on uncertainty is no more difficult than other parts of the book, but a few
sections are more complex. With uncertainty no one measure of value can fully
capture all the elements that must be considered to make the decision.
Project evaluation must take into account the competitive position of the firm
undertaking the project. Forecasting future cash flows requires estimates of the
future prices of inputs and outputs.The accuracy of such forecasts can be increased
if the project analyst gives careful consideration to the nature of the competition
in the input and output markets and to the firms position in that competitive
picture. Frequently, firms develop a strategic plan designed to achieve expansion
in favorable areas and limit expansion in product lines that are considered to be
unfavorable. The interrelations between strategic planning and project analysis
need consideration.
We present intuitive solutions to capital budgeting decisions in the early
chapters. An understanding of this basic material will avoid certain types of errors
in evaluating investments. Even though it will not give exact answers to all the
types of complex problems that managers must solve, it will help improve
decision-making.
In addition to the questions at the end of each chapter, at the end of the book
we have included one case for each chapter.All except a few of the cases are drawn
from actual business corporations.
We wish to thank our colleagues Jerry Hass and Bhaskaran Swaminathan for
interesting and useful conversations and Gary Parikh, an enthusiastic reader of past
editions of the book who has found and corrected a significant number of errors.

xviii

Extracts from the preface


to the first edition

Sirs: The Indian who sold Manhattan for $24.00 was a sharp
Salesman. If he had put his $24 away at 6% compounded
semiannually, it would now be $9.5 billion and could buy most of the
now-improved land back.1
S. Branch Walker, Stamford, Conn., Life, August 31, 1959

Businessmen and economists have been concerned with the problem of how
financial resources available to a firm should be allocated to the many possible
investment projects. Should a new plant be built? Equipment replaced? Bonds
refunded? A new product introduced? These are all to some extent capital budgeting decisions to which there are theoretically sound solutions.The purpose of this
book is to express the solution of the economist in the language of the business
manager.
Decades ago, economists such as Bohm-Bawerk,Wicksell, and Irving Fisher laid
the theoretical foundation for a sound economic approach to capital budgeting. In
recent years the technical literature has contained articles (such as those by Dean,
Solomon, Lorie, Savage, and Hirshleifer) that have significantly increased our
understanding of the requirements for sound capital budgeting decisions.
However, these publications have not been directed toward business managers and,
until recently, the work of these men had had no perceptible influence on the way
businessmen actually made capital investment decisions. Businesses have tended
to make capital budgeting decisions using their intuition, rules of thumb, or
investment criteria with faulty theoretical foundations and thus have been likely to
give incorrect answers in a large percentage of the decisions.

1 Extending Mr. Walkers value analysis to 2006, the $9.5 billion would have grown to $147 billion
assuming 6 percent compounded annually for an additional 47 years.

xix

EXTRACTS FROM THE PREFACE TO THE FIRST EDITION

The purpose of this book is to present for an audience who may be completely
unfamiliar with the technical literature on economic theory or capital budgeting a
clear conception of how to evaluate investment proposals.
Harold Bierman, Jr.
Seymour Smidt
Ithaca, New York

xx

Chapter 1

Investment decisions and


corporate objectives

One questioner asked Mr. Sloan if he had made any mistakes in 40


years as a top executive of General Motors and added: Think of one.
I dont want to keep you up all night, Mr. Sloan snapped. The
executive who makes an average of 5050 is doing pretty good.
Exchange between Alfred P. Sloan, a long-time
Chairman of General Motors, and a journalist, reported
by The New York Times on January 17, 1964

The primary motivation for investing in the common stock of a specific corporation
is the expectation of making a larger risk-adjusted return than the investors
require.The managers of a corporation have the responsibility of administering the
firms affairs in a manner consistent with the expectation of returning the
investors original capital plus the desired return (or more) on their invested capital. The common stockholders are the residual owners, and they earn a return
only after the investors holding the more senior securities (debt and preferred
stock) have received their contractual claims.We will assume that one of the firms
primary objectives is to maximize its common stockholders wealth position. But
even this narrow, relatively well-defined objective is apt to be difficult to execute.
Situations frequently arise in which one group of stockholders will prefer one
financial decision, while another group of stockholders will prefer another
decision. Also, there are many other alternative objectives (e.g. concern for
community, the welfare of management and other employees, and satisfying
customers) that need to be considered.
Imagine a situation in which a business undertakes an investment that its
management believes to be desirable, but the immediate effect of the investment
will be to depress annual earnings in the short term and thus lower the common

INVESTMENT DECISIONS AND CORPORATE OBJECTIVES

stock price today, because the market does not have the same information as
management. Management expects that in the future the market will realize the
investment is desirable, and the stock price will then reflect the enhanced value. A
stockholder expecting to sell the stock in the near future would prefer that the
investment had been rejected, whereas an investor holding the stock for the long
run might be pleased that the investment was undertaken. The problem might be
mitigated to some extent by improving the information available to the market.
Then todays market price would better reflect the actions and plans of management. However, in practice, the market does not have access to the same information
set as management does (this is a situation of asymmetric information).
A corporate objective such as profit maximization does not adequately
describe the primary objective of the firm. Current accounting profits, as
conventionally computed, do not effectively reflect the cost of the stockholders
capital that is tied up in the investment, nor do they reflect the long-run benefit of
a recent decision on the shareholders wealth. Total sales or share of product
market objectives are also inadequate normative descriptions of corporate goals,
although achieving an increase in sales or share of market may also lead to the
maximization of the shareholders wealth position, by their positive incremental
effect on profits.
It is recognized that a complete statement of the organizational goals of a
business enterprise beyond maximizing shareholder value might embrace a much
wider range of considerations, including such things as the prestige, income,
security, freedom, and power of the management group, and the contribution of
the corporation to the overall social environment in which it exists and to the
welfare of the labor force it employs. Since the managers of a corporation should
be acting on behalf of the common stockholders, the managers have a fiduciary
responsibility to the stockholders.The common stockholders, the primary suppliers
of the risk capital, have entrusted a part of their wealth to the firms management.
Thus the firms success and the appropriateness of managements decisions must
be evaluated in terms of how well this fiduciary responsibility has been met.While
we define the firms primary objective of the firm to be the maximization of the
value of the common stockholders ownership rights in the firm, we recognize that
any corporation is likely to have other objectives.

INVESTMENT DECISIONS
Business organizations are continually faced with the problem of deciding whether
the current commitments of resources are worthwhile in terms of the present
value of the expected future benefits. If the benefits are likely to accrue reasonably
soon after the expenditure is made, and if both the expenditure and the benefits
can be measured in dollars, the analysis of the problem is more simple than if the

INVESTMENT DECISIONS AND CORPORATE OBJECTIVES

expected benefits accrue over many years and there is considerable uncertainty as
to the amount of these benefits.
We shall use the term investment to refer to commitments of resources made in the
hope of realizing benefits that are expected to occur in future periods. Capital budgeting is a many-sided activity that includes searching for new and more profitable
investment proposals, investigating engineering and marketing considerations to predict the consequences of accepting the investment, and making economic analyses to
determine the profit potential of each investment proposal.
Corporate managers have to decide on the direction their corporation will
go (strategic decisions) as well as how to implement the strategic decisions
(tactical decisions).We describe both types of decisions with the term capital budgeting decisions. All capital budgeting decisions have time as an important element.
Outlays are made today to benefit the future.
Because corporate managers typically do not know the future, there is
uncertainty. It is necessary to allocate resources without knowing the exact
consequences of the decisions.The objectives of this book are to offer suggestions
on how to make informed and intelligent capital budgeting decisions in a reasonable
manner and also how to avoid making some subtle but very important errors.
Any good capital budgeting decision process must effectively take into
consideration four basic factors:

time value of money;


risk considerations;
alternative investments;
future opportunities.

A fifth factor falls within risk considerations but is worthy of its own classification.
The timing of the information that removes or reduces uncertainty is also of
importance in valuation.
Unfortunately, there are several widely used computational methods which
seem to consider both time and risk, but have flaws that can readily lead to faulty
decisions (decisions in retrospect that should be different from the decision
indicated by the calculations).These methods frequently have the virtue of relative
simplicity, but they should not be used without supplemental calculations that can
confirm or invalidate the conclusions.

THE LIMITATIONS OF QUANTIFICATION


This books objective is to quantify the investment decision in order to improve the
decision process. Measures of value will be determined to indicate whether or not
a project (or projects) should be undertaken. Unfortunately, it is a frustrating

INVESTMENT DECISIONS AND CORPORATE OBJECTIVES

paradox that the larger and the more important the decision, the more likely it is
that relevant reliable quantified measures of value will not be available.The outcomes
are more uncertain.
In each industry there are opportunities involving very large outlays with uncertain
benefits. Frequently, these decisions must be made based on informed business
judgment rather than on a single calculation indicating a go or no-go decision.

THE STATE OF BUSINESS PRACTICE


Business practice is very good at taking into consideration the time value of money.
The formula (1  r)n is universally used to transform future dollars into their
present value equivalents. The interest rate (r) either takes into consideration the
pure time value (using a risk-free rate), the risk of the corporation (the firms
weighted average cost of capital), the risk of the operating unit (plant or division),
the risk of the specific project being evaluated or the risk of the specific cash
flow component. Obviously, all of the above cannot be right. We will attempt to
offer suggestions that are both practical and more theoretically correct than
current practice.

TIME, RISK, AND THE RISKRETURN TRADE-OFF


The two primary factors that make finance an interesting and complex subject are
the elements of time and risk. Because decisions today often affect the cash flows for
many future time periods and the outcomes of the actions are uncertain, we need
to formulate decision rules that take risk and time value into consideration in a
systematic fashion.The capital budgeting decision is as intellectually challenging as
any problem that one is likely to encounter in the world of economic activity.
Frequently, the existence of uncertainty means that the decision-maker faces
alternatives that involve trade-offs of less return and less risk or more return and
more risk. A large part of the study of finance has to do with learning how to
address these riskreturn trade-off choices.

THREE BASIC GENERALIZATIONS


We offer three generalizations that are useful in the types of financial decisions to
be discussed.The first generalization is that investors prefer more return (cash and
value) to less, all other things being equal (risk is held constant).
The second generalization is that investors are risk averse.They prefer less risk
(a possibility of loss) to more risk and have to be paid to undertake risky endeavors.

INVESTMENT DECISIONS AND CORPORATE OBJECTIVES

This generalization may seem contrary to common observations, such as the


existence of race tracks and gambling casinos (the customers of such establishments are willing to pay for the privilege of undertaking risky investments), but
the generalization is useful even if it does not apply to everyone all the time.
The third generalization is that cash to be received today is preferred to the
same amount of cash to be received in the future. This generalization is valid
because the funds received today can be invested to earn some positive return or
can be used to reduce outstanding interest paying debt. Since this is the situation
in the real world, the generalization is reasonable.
These three generalizations are used implicitly and explicitly throughout the book.

RELEVANCE OF CASH FLOWS


Given the objective to maximize the stockholders wealth, how should individual
investment alternatives and other financial decisions be evaluated? For a publicly
traded firm, it may be convenient to assume that the market value of the stock is
a reasonable measure of its value to the shareholder.The markets assessment of the
firms future is incorporated in the stock price, even though this assessment is
frequently going to be proven in the future not to be accurate.At any moment, the
markets assessment of the value of some firms is too high, while its assessment of
the value of other firms is too low, compared to the values that ultimately occur
through time. Unfortunately, there is no means by which even well-informed and
astute investors with the best of models can identify with certainty which firms are
overvalued and which are undervalued. For most investors, who are not in
possession of special inside information (information known only to persons
working for or with a firm or talking with such people), the market value of a firm
is the best available measure of its value. For the privately held firm, for which
there is no regularly reported market value, the wealth position of the owner is
even more difficult to assess than where there is a market valuation.
Theoretically, alternative actions should be evaluated based on the extent to
which they will improve the market value of the stock, and those ethical and legal
actions leading to a maximization of stock value should be chosen. Unfortunately,
although this strategy is theoretically correct, we cannot always forecast the
consequences of decisions.
Any decision that is expected to alter the anticipated cash flows of the firm is
likely to alter the value of the firms common stock. Cash is the common element
in all decisions. Any decision can be characterized by the set of incremental cash
flows that its acceptance is expected to cause.Thus, most decisions can be reduced
to evaluating incremental cash flows.
It would be an overstatement to say that all decisions can be characterized and
evaluated in terms of incremental cash flow, since some aspects of decisions are

INVESTMENT DECISIONS AND CORPORATE OBJECTIVES

wholly nonquantifiable.Yet most business decisions can and should be expressed in


cash flow terms. Even decisions that have large elements that do not lend themselves
to exact cash flow analysis have segments that can be described in cash flow terms.
For example, we may not be able to quantify the expected benefits of a research
project, but we should be able to define the cash flows of the costs to be incurred.
This information, when compared with rough estimates of gains, if successful, may
be sufficient to determine if proceeding with the research is desirable.

CASH FLOWS VERSUS EARNINGS


A decision may be characterized by its effect on accounting earnings, as well as by
its incremental cash flows. The forecasted earnings and cash flows would lead to
consistent decisions if earnings were computed in accordance with very special
rules.Thus, you should not be concerned that cash flows are being used to evaluate
decisions in this book.There is no essential conflict with the use of cash flows and
the use of good accounting earnings to evaluate investments.
We consider future cash flows to be a relevant measure of the impact of a
decision on the firm and will use anticipated cash flows as the primary input in
the decision to be analyzed. After the decision has been made, the actual income
measures tend to be easier to use than actual cash flows as inputs into performance
measurement calculations.

THE CAPITAL MARKET


All corporations at some stage in their life go to the capital market to obtain funds.
The market that supplies financial resources is called the capital market and it
consists of all savers (banks, insurance companies, pension funds, individuals,
etc.). The capital market gathers resources from the savers of society (individuals
or organizations consuming less than they earn) and rations these savings to those
entities that have a need for new capital and that can pay the price the capital
market defines for capital.
The availability of funds (the supply) and the demand for funds determine the
cost of funds to the organizations obtaining new capital and the return to be earned
by the suppliers of capital. The measure of its cost of capital becomes very
important to a business firm in the process of making decisions involving the use
of capital. We shall have occasion to use the market cost of funds (the market
interest rate) frequently in our analyses, and the price of capital set by the capital
market is relevant to the firms decisions.
Actually, there is not one market cost of funds; rather, there is a series of
different but related costs, depending on the specific terms of the specific capital

INVESTMENT DECISIONS AND CORPORATE OBJECTIVES

being used and the amount of risk associated with the security that is issued. One
of the important objectives of this book is to develop an awareness of the cost of
the different forms of capital (common stock, preferred stock, debt, retained
earnings, etc.) and the factors that determine these costs. The cost of a specific
form of capital for one firm will depend on the returns investors can obtain from
other firms, based on the characteristics of the assets of the firm that is attempting
to raise additional capital, and on the firms capital structure. We can expect that
the larger a firms risk, the higher the expected return that will be needed to
attract investors to the firm.

THE WEIGHTED AVERAGE COST OF CAPITAL


For many years, the most commonly used discount rate for computing a projects
net present value has been the firms weighted average cost of capital (WACC).The
firms risk helps determine the value of its WACC.
Where a projects risk is significantly different from the firms risk, the use of
the firms WACC is not theoretically correct and might lead the firm to make an
incorrect investment decision. The WACC of each project can be estimated and
used as a discount rate. The decision-maker can be even more exact and use a
discount rate for each cash flow component (contribution margin, depreciation tax
shield, etc.) that is consistent with the risk characteristics of that component.

TACTICAL AND STRATEGIC DECISIONS


Investment decisions may be tactical or strategic. A tactical investment decision
generally involves a relatively small amount of funds and does not constitute a
major departure from what the firm has been doing in the past.The analysis to buy
or not buy a new machine tool is a tactical decision, as is a buy or lease decision.
Strategic investment decisions involve large sums of money and may also result
in a major departure from what the company has been doing in the past. Strategic
decisions directly affect the basic course of the company. Acceptance of a strategic
investment will involve a significant change in the companys expected profits and
in the risks to which these profits will be subject.These changes are likely to lead
stockholders and creditors to revise their evaluation of the company. If a private
corporation manufacturing airplanes undertook the development of a supersonic
commercial transport (costing many billions of dollars), this would be a strategic
decision. If the company failed in its attempt to develop the commercial plane, the
very existence of the company would be jeopardized. Frequently, strategic
decisions have to be based on intuition due to the lack of detailed reliable
quantitative analysis. Considering the effect of a decision made today on future

INVESTMENT DECISIONS AND CORPORATE OBJECTIVES

decisions of the firm and its ultimate competitive position involves strategic decisions
(it also may be an application of option theory).

THE ROLE OF STRATEGIC PLANNING


Strategic planning guides the search for projects by identifying promising product
lines or geographic areas in which to search for good investment projects. One
firm may seek opportunities for rapid growth in emerging high-technology
businesses. Another may seek opportunities to become the low-cost producer of
commodities with well-established technologies and no unusual market problems.
A third firm may look for opportunities to exploit its special knowledge of a
particular family of chemicals. A strategic plan should reflect both the special skill
and abilities of the firm (its comparative advantage) and the opportunities that are
available as a result of dynamic changes in the world economy.
Strategic planning leads to a choice of the forest; project analysis studies and
chooses between individual trees. The two activities should complement and
reinforce each other.
If attractive projects are not found where the strategic plan had expected them,
or if desirable projects appear in lines of business that the strategic plan had
identified as unattractive, a reassessment of both the project studies and the
strategic plan may be in order.

THE TWO CAPITAL BUDGETING REVOLUTIONS


The first capital budgeting revolution occurred over the time period of 1950 to
1980. It involved the replacement of payback (time till the initial investment is
recovered) and accounting return on investment as the primary methods of
evaluating investment alternatives. The percentage of firms using discounted cash
flow methods (net present value and internal rate of return) rose from 4 percent
in the 1950s to over 90 percent in the late 1980s.Today there are few, if any, major
corporations who do not use one or more discounted cash flow methods.
The second revolution actually started soon after the first revolution was launched.
There has long been dissatisfaction with the methods of coping with uncertainty.The
following are the primary elements of the second capital budgeting revolution:
1
2

Improved valuation of investment opportunities (valuation of real options).


A shift from using the firms weighted average cost of capital to a discount rate
that has been determined for a specific project or cash flow component.This
Risk-Adjusted Discount Rate or RADR, should reflect the risk of the specific
project being evaluated.

INVESTMENT DECISIONS AND CORPORATE OBJECTIVES

3
4

A recognition that the different cash flow components of a project might


require their own discount rates.
A realization that (1  r)n with r incorporating a risk adjustment factor
might not be the best method of taking time value and risk into consideration,
if risk does not compound through time.
The necessity of considering when uncertainty is resolved and to include this
consideration in the present value calculation.

Taking all these factors into consideration implies that it may not be adequate to
evaluate investment alternatives using conventional discounted cash flow calculations
using the firms WACC and (1  r)n as the discounting factor. However, these
calculations are the foundations of any capital budgeting process.

CONCLUSIONS
The basic building blocks of this book are three generalizations that are introduced
in this chapter:
1
2
3

All things being equal, investors prefer more expected return to less.
All things being equal, investors prefer less risk to more risk.
Investors prefer an amount of cash to be received earlier to the same amount
to be received later.

Many investors accept or seek risk, but they normally do so with the hope of some
monetary gain that is consistent with the amount of risk. They expect to be
compensated for the risk they undertake. Some investors actually like risk, but
they are a minority.
Corporations and the managers running the corporations have many different
goals.We have simplified the complex set of corporate objectives that exist to one
basic objective: the maximization of the value of the stockholders ownership
rights in the firm.While reality is more complex, this simplification enables us to
make specific recommendations as to how corporate investment decisions (capital
budgeting decisions) should be made.
We shall find that, while some investment decisions may be solved exactly,
sometimes we shall only be able to define and analyze the alternatives.We may not
always be able to identify the optimum decision with certainty, but we shall
generally be able to describe some errors in analysis to avoid. With investment
decisions, useful insights for improved decision-making can be obtained by
applying modern finance theory.
If the discount rate is excessively large, the NPV calculation creates a bias
against long-lived assets. If the discount rate is reasonably measured, then the

INVESTMENT DECISIONS AND CORPORATE OBJECTIVES

reduction in value of a future cash flow for time value is consistent with good
theory.

POP QUIZ 1.1


A Company increased its annual earnings to stockholders by $10,000,000. Which
of the following best describe the situation?
a Management should be praised.
b We want to know the rate of growth (percentage increase) before reaching a
conclusion.
c We want to know the incremental amount of stockholder capital required to
produce the $10,000,000 increase.

PROBLEMS
1
2
3
4

5
6

Can a firm have income without also having a positive cash flow? Explain.
If a firm currently earning $1 million can increase its accounting income to
$1.1 million, is this a desirable move? Explain.
A sales manager is proud of having doubled sales in the past four years.
What questions should be asked before praising the manager?
A president of an automobile manufacturing firm has the opportunity to double
the firms profits in the next year. To accomplish this profit increase, the quality
of the product (currently the prestige car of the world market) must be
reduced. No additional investment is required. What do you recommend?
Name an economic cost that is omitted from the accounting income
statements that should be of interest to management.
The ABC Company has to make a choice between two strategies:
Strategy 1: Is expected to result in a market price now of $100 per share of
common stock and a price of $120 five years from now.
Strategy 2: Is expected to result in a market price now of $80 and a price of
$140 five years from now.
What do you recommend? Assume that all other things are unaffected by
the decision being considered.
It has been said that few stockholders would think favorably of a project that
promised its first cash flow in 100 years, no matter how large this return.
Comment on this position.
Each of the following is sometimes listed as a reasonable objective for a
firm: (a) maximize profit (accounting income), (b) maximize sales (or share

10

INVESTMENT DECISIONS AND CORPORATE OBJECTIVES


of the market), (c) maximize the value of a share of common stock t time
periods from now, (d) ensure continuity of existence, (e) maximize the rate of
growth, (f) maximize future dividends. Discuss each item and the extent of its
relevance to the making of investment decisions.

ANSWER TO POP QUIZ 1.1


Answer (c) is best. If $500,000,000 of stockholder capital resulted in the
$10,000,000 earnings increase, that return (0.02) does not deserve praise.
Answer (b) is reasonable. The rate of growth is interesting.

BIBLIOGRAPHY
A number of excellent introductory and intermediate financial management texts
are available to be used in conjunction with this book to provide a parallel
description of many of the decisions we discuss and to fill the reader in on
institutional material. Among them are the following:
Brealey, R. and S. Myers, Principles of Corporate Finance, 6th edn., New York:
McGraw-Hill, 2000.
Copeland, T. E. and J. F. Weston, Financial Theory and Corporate Policy, 3rd edn.,
Reading, Mass.: Addison-Wesley, 1988.
Fama, E. F. and M. H. Miller, The Theory of Finance, New York: Holt, Rinehart &
Winston, 1972.
Van Horne, James C., Financial Management and Policy, 12th edn., Englewood
Cliffs, NJ: Prentice-Hall, 2002.

11

Chapter 2

The time value of money

The frenetic buying of Internet stocks is going to make the tulip


buyers of the 17th century look like value players.
Rick Berry, director of equity research at J. P. Turner &
Company in Atlanta. The New York Times, January 9, 1999

Compound interest is one of the wonders of this world. It is the basis of the
present value calculations.The Safra Bank issued bonds that mature in 1,000 years.
The present value of $1,000,000,000 of principal payments of this bond at a 0.08
annual interest rate is much less than $0.01. Compound interest is very powerful.
A future sum may have a very small present value. A very small present amount
might grow to a large sum in the future.
To better understand the time value of money, we shall first assume that both
the discount rate and the dollar amounts are known with certainty.These assumptions
enable us to establish basic mathematical relationships and to compute exact
relationships between future sums and their present values.

TIME DISCOUNTING
One of the basic concepts of business economics and managerial decision-making
is that the present value of an amount of money is a function of the time of receipt
or disbursement of the cash. A dollar received today is more valuable than a dollar
to be received in some future time period.The only requirement for this concept to
be valid is that there be a positive rate of interest at which funds can be invested or
borrowed.
The time value of money affects a wide range of business decisions, and how to
incorporate time value considerations systematically into a decision is essential to
an understanding of finance. The objective of this chapter is to develop skills in

12

THE TIME VALUE OF MONEY

finding the present equivalent of a future amount or future amounts and the future
equivalent of a present amount.

Symbols used
X

Xt

Cash flow. If X is greater than zero there is a cash inflow. If X is


less than zero, there is a cash outflow.
Time index. It can refer to a point in time or an interval (for
example, t years from now).
Cash flow at end of period t.

Summation symbol as in

(1  r)t

Future value of a dollar invested for t periods at a rate of r per


period, compounded once per period. It equals the quantity
(1  r) multiplied by itself t times.The quantity (1  r) taken to
the t-th power.
Present value of a dollar to be received at the end of period t
using a rate of r per period. Equals one divided by (1  r) to the
t-th power.
Present value of future cash flows.
Future value at time t of present cash flows.

(1  r)t

PV
FVt

Xt  X1  X2  X3.
t1

FUTURE VALUE
Assume that you have $1 now and can invest it to earn 10 percent per period. After
one period you will have the $1 plus $0.10, the amount earned on the $1. Repeat the
process for a second period. The amount available at the beginning of period two is
$1.10. The amount earned during the second period is 0.1($1.1)  $0.11. Adding
this to the initial amount we have $1.10  $0.11  $1.21 at the end of period 2.
This process can be generalized. Let X0 be the amount available at the beginning
of period 1, let FVn be the future cash flow available at the end of period n, and let
r be the interest rate per period.Then for n  1,
FV1  (1  r)X0
Repeating the process, at time 2 you will have an amount FV2, where
FV2  [(1  r)  r(1  r)]X0  (1  r)2X0
Thus, the future value of $X0 invested for n periods at an interest rate of r per
period is
FVn  (1  r)nX0

(2.1)

13

THE TIME VALUE OF MONEY

If r  0.10, n  2 and X0  $1, we have


FV2  (1  r)nX0  (1.10)2$1  (1.21)$1  $1.21
If instead of X0  $1 we start with X0  $50, the value of the cash flow at time 2 is
FV2  (1.10)2$50  (1.21)$50  $60.50
Equation (2.1) is the standard compound interest formula for the future value
of a present sum. The term (1  r)n is called the future value factor or the
accumulation factor. It gives the future value of $1 invested for n periods at an interest
rate of r. The specific numerical value of the future value factor is a function of the
values of n and r. Denote the future value factor function by FVF(n,r). We
previously found FVF(2, 0.10) to be equal to 1.21. To find the future value factor
for n  4 and r  0.05 we take 1.05 to the fourth power.
FVF(4, 0.05)  (1.05)4  1.2155
In general, the future value factor function can be written as
FVF(n, r)  (1  r)n

(2.2)

The power of compounding (earning interest on interest) is dramatic. It can be


illustrated by computing how long it takes to double the value of an investment.
Table 2.1 shows these periods for different values of r.
A useful rule of thumb in finance is the double-to-72 rule, where for wide
ranges of interest rates, r, the approximate doubling time is (72/100r) periods.
Note how closely the rule approximates the values in Table 2.1.With a 0.10 time
value factor, an investment will double in value every 7.3 years.The rule of thumb
gives 7.2 years.

Table 2.1 Time until doubling

14

Interest rate (r)

Time until initial


value is doubled

0.02
0.05
0.10
0.15
0.20

35.0 years
14.2
7.3
5.0
3.8

THE TIME VALUE OF MONEY

To make business decisions we frequently want to work with present values


instead of future values.

PRESENT VALUE
Today almost all large firms use some form of discounted cash flow (DCF)
techniques in their capital budgeting (investment decision-making). To perform a
DCF analysis, we must find the present value equivalents of future sums of money.
For example, if the firm receives $100 one year from now, as a result of a decision,
we want to find the present value equivalent of the $100. The present value of
$100 received at time one is the answer to the question of how much money must
be invested now in order to have $100 one year from now.
Algebraically the question can be answered by using the future value equation
where the future value is known and we solve for the present sum.The future value
in year one for an arbitrary sum X0 using a discount rate of 0.10 is
FV0  X0(1  0.10)1
If we know that the future value is equal to $100, we can set this equation equal to
$100 while leaving X0 as the unknown.This gives
X0(1  0.10)1  $100
In this equation, X0 is the present value of $100 in one year at 10 percent. Solving
for X0 gives:
X0 

$100
 $100(1  0.10)1  $90.91
(1  0.10)1

Therefore, if the money can earn 0.10 (10 percent) per year, then $100 to be
received one year from now is worth $90.91 now.
This can be verified by noting that $90.91 invested to earn 0.10 will earn $9.09
in one year. Thus, the investor starting with $90.91 will have $100 at the end of
the year when the $9.09 earnings are added to the $90.91 initial amount
($9.09  $90.91  $100). An investor with excess funds who can earn 0.10 on
money invested will be indifferent between receiving $100 at the end of the
year or $90.91 at the beginning of the year. Remember, we are assuming no
uncertainty.
The rate at which money invested can earn a return has various names depending
on the context.The rate at which money is earned by making a loan is an interest rate.
The rate at which money is earned by investing in a business is an earnings rate.

15

THE TIME VALUE OF MONEY

We use the terms discount rate or time value of money as generic terms for any
situation in which discounted cash flow calculations are relevant.
If the 0.10 rate applies for two periods, the investor will be indifferent about
receiving $82.64 today or $100 two years from today. If the $82.64 is invested to
earn 0.10 per year, the investor will have $90.91 ( $82.64  $8.26) after one
year and $100 at the end of two years.
The unit of time can be a unit of time other than a year, but the unit of time for
which the discount rate is measured must be the same as the unit of time used to
measure the timing of the cash flows. In the previous example, the 0.10 is defined
as the discount rate per year and is applied to a period of one year.
Present values can be found by starting with equation (2.1) and treating the
quantity FVn as known and the quantity X0 as the unknown. Re-arranging equation
(2.1) so that the quantity X0 is isolated on the left-hand side we have
X0 

FVn
Xn
n or Xo 
(1  r)
(1  r)n

The term 1/(1  r)n is commonly written as (1  r)n. Using this notation, the
above equation can be written as
X0  Xn(1  r)n

(2.3)

The quantity (1  r)n is called the present value factor, and may be denoted as PVF.
The present value factor gives the present value of a future $1.The specific numerical value of the present value factor is a function of the values of n and r. Denote the
present value factor function by PVF(n, r). To find the present value of Xn dollars,
multiply Xn by the appropriate present value factor. For example, if the future amount
to be received at time 2 is X2  50, and the discount rate is 0.10, then the PVF is
(1.1)2  0.8264, and the present value of the amount is $41.32 [  50(0.8264)].
In general, the present value factor function can be written as:
PVF(n, r)  (1  r)n

(2.4)

Combining equations (2.2) and (2.4) we note that


1
PVF(n, r)  FVF(n,
r)

and

1 .
FVF(n, r)  PVF(n,
r)

COMPUTING PRESENT VALUE FACTORS


There are three common methods for finding present value factors: tables, hand
calculators, and personal computers.

16

THE TIME VALUE OF MONEY

The present value factors for various combinations of time periods and discount
rates are found in Appendix Table A at the back of this book.
Any hand calculator with the capability to compute yx can be used to compute
the present value factors directly. If yx is used, then y  1  r and x  n.To find the
present value factor for r  0.10 and n  5 using a typical calculator requires
the following steps: place 1.1 in the calculator, press the yx button, insert 5, press the
/ button to change 5 to minus 5, and press the  button to find 0.62092.
A third method is to use a spreadsheet program on a personal computer.

CALCULATING PRESENT VALUE FACTORS USING THE


HEWLETT-PACKARD 12C CALCULATOR

The popular HP12C is especially designed for financial calculations. The


keystrokes used are different from those used in most other hand
calculators.

USING THE ORDINARY KEYS

To calculate the PVF(n, r) or (1  r)n for n  5 and r  0.10 first press


1.1 and then press the Enter key. Next press 5 and then the CHS key, which
will change the 5 to minus 5. Finally, press the YX key. The present value
factor will appear in the display.

USING THE SPECIAL FINANCIAL FUNCTION KEYS

First press the yellow f key and then the x 


 y key. This clears the special
storage registers used for the financial functions. To calculate PVF(n, r) for
n  5 and r  0.10 first press 1 and then depress the CHS key followed by
the FV key. Press 5 and then depress the n key. Press 10 and then depress
the i key. Then depress the PV key. The word running will briefly appear
flashing in the calculator display. Then the present value factor should
appear in the calculator display.

With a typical spreadsheet program, define three one-cell ranges named FV, n,
and R_. Enter the values of the future cash flow, the number of periods, and
the discount rate in the corresponding cells. Then, in the fourth cell, type the
present value formula fv * (1  r_) (n), which is equivalent to
FV(1  R)n

17

THE TIME VALUE OF MONEY

Enter the formula into the cell by depressing the return key. If your spreadsheet
is set for automatic recalculation (this is usually the default setting), the contents of
the cell should show the present value of the future amount FV.To find a different
present value, change the entries in the FV, n, or R_ cells. The present value cell
will be instantly updated. (Beware: If your spreadsheet has a function labeled PV
or @PV, it probably gives the present value of an annuity, not the present value
of a single payment.)

CALCULATING PRESENT VALUE FACTORS USING THE EXCEL


SPREADSHEET PROGRAM
Hint 1

The Excel spreadsheet will refuse to accept R (or r) as a range name. If


you try to use R, either the spreadsheet will refuse to create the range, or it
will create it but change the name to R_ or r_. Excel doesnt have such
problems with most other one-letter range names. If you can find out why,
let us know the answer. In the meantime, just use R_ , in defining the range
name and in the formulas that refer to it.
Hint 2

A quick way to define three one-cell ranges is the following. First, enter the
range names FV, n and R_ in three adjacent cells in one column. Then,
select those three cells and the three cells in the column immediately to
their right. While these six cells are selected use the Insert Name Create
command sequence and make sure the left column button in the Create
Names dialogue box is checked and the other buttons are blank before
clicking the OK button. Excel will use the labels in the left column to assign
names to the cells immediately to their right.
Hint 3

When you are entering a formula that refers to a name Excel is not sensitive
to whether you enter upper-case or lower-case letters. However, when it
displays your formula, it will always change the case of the characters to
match the case of the range name. Some programmers use these conventions
to their advantage. They always define range names using only capital
letters, and they always enter formulas using only lower-case letters. If there
is a typo in typing a range name used in the formula, it will be easy to spot
because the misspelled range name will still be in lower-case letters.

18

What is the present value of $1 to be received three time periods from now if
the time value of money is 0.10 per period?
In Appendix Table A, the number in the 0.10 column and the line opposite n
equal to 3 is 0.7513. If you invest $0.7513 to earn 0.10 per year, after three
years you will have $1. Also, (1.10)3  0.7513.
What is the present value of $100 to be received three time periods from now
if the time value of money is 0.10? Since (1.10)3  0.7513, the present value
of $100 is
PV  $100(0.7513)  $75.13
If $75.13 is invested at time 0, and each periods earnings are re-invested at
the same 0.10 rate, the following growth takes place.
Period
(t)
0
1
2

Investment at
beginning of period
$75.13
82.643
90.907

Earnings
$7.513
8.264
9.091

Investment at
end of period
$82.643
90.907
100.000

If investors with excess funds can earn 0.10 per period, then they are indifferent
between $75.13 received at time 0 or $100 at time 3.
With present value factors, we can compute the present value of any single
cash flow. But in most applications we need to be able to compute the present
value of a sequence of cash flows. There are a few general rules that can be
used to calculate the present value of any sequence of cash flows. The first rule
is called the present value addition rule.

Present value addition rule


The present value of any set of cash flows is the sum of the present values of each
of the cash flows in the set.

Present value multiplication rule


The present value factor for n years is equal to the product of the present value
factor for t years and the present value factor for (n  t) years.
For example, using an 8 percent discount rate, the present value factor for a
dollar to be received in 3 years is 0.7938, and the present value factor for a dollar
in 9 years is 0.5002. Therefore, the present value of a dollar in 12 years is
0.7938 0.5002  0.3971.
The present value multiplication rule applies even if the applicable discount rate
is not the same for each group of years.

19

EXAMPLE 2.1

THE TIME VALUE OF MONEY

EXAMPLE 2.2

THE TIME VALUE OF MONEY

An amount of $100 is to be received at the end of period one, and an amount of


$200 at the end of period two. The time value of money is 0.10. What is the
total present value of two cash flows? Using the present value addition rule we
can calculate the present value of each cash flow, and then add the present
values. The calculations are shown in the following table.
Period t

Cash flow Xt

1
2

$100
200

Present value factors


PVF(t, 0.10)
0.9091
0.8264
Total present value using 0.10 

Present value
PV
$ 90.91
165.28
$256.19

By using the formula for the present value of a future cash flow and the present
value addition rule, one could calculate the present value of any possible set of
discrete cash flows.

For example, suppose $100 is to be received in 12 years. The discount rates


are 12 percent for the first 3 years and 6 percent for the next 9 years.The present
value factor for $1 in 3 years at 12 percent is 0.71178.The present value factor for
a dollar in 9 years at 6 percent is 0.59190. The present value of the $100 to be
received in 12 years is $100 (0.71178) (0.5919)  $42.13.

Present value of an annuity


An annuity is a sequence of n equal cash flows, one per period. If the first payment
occurs one period from now, the annuity is called an ordinary annuity or an
annuity in arrears. Let B(n, r) represent the present value of an ordinary annuity.
The interest rate is r per period, and there are n payments of $1 at the end of each
of the n periods. It is shown in Appendix 2.1 of this chapter that the present value of
an ordinary annuity is:
B(n, r) 

1  (1  r)n
r

(2.5)

Many practical problems require knowing the present value of an annuity, and
using this formula is easier than computing the present value of the cash flow of
each year individually.
Appendix Table B at the back of this book gives the present values of ordinary
annuities of $1 per period for different values of r and n. Many hand calculators
also are equipped for computing the present value of an annuity.
If X dollars are received at the end of each period instead of $1, we can multiply
the present value of $1 per period by X to obtain the present value of X dollars per

20

THE TIME VALUE OF MONEY

period. That is, for an ordinary annuity for X dollars per period, the present
value is
PV  XB(n, r)

The ABC Company is to receive $1 a period for three periods, the first payment
to be received one period from now. The time value factor is 0.10. Compute the
present value of the annuity. There are three equivalent solutions:
1
2

From Appendix Table B,


B(3, 0.10)  2.4869
Using equation (2.5),
B(3, 0.10) 

1  (1  r)n 1  0.75131 0.24869




 2.4869
r
0.10
0.10

To confirm the correctness of 2.4869 add the first three entries in the 0.10
column in Appendix Table A,
(1.10)1  0.9091
(1.10)2  0.8264
(1.10)3  0.7513
B(3, 0.10)  2.4868

If, instead of $1 per period, the amount is $100, then using equation (2.6), we
would multiply $2.4869 by $100 and obtain $248.69.
When the payments occur at the end of each period, we have an ordinary
annuity. When the payments occur at the beginning of each period, we have
an annuity due (also called an annuity in advance). Equation (2.5), repeated
here, gives the present value of an ordinary annuity.
B(n, r) 

1  (1  r)n
r

(2.5)

If we have (n  1) payments, with the first payment taking place immediately,


we would merely add $1 to the value of the preceding equation. Thus, if
B(3, 0.10) equals $2.4868, a four-payment annuity with the first payment at
time 0 would have a present value of $3.4868. An n-period annuity due is a
(n  1) period ordinary annuity plus the initial payment.

Present value of a perpetuity


A perpetuity is an annuity that goes on forever (an infinite sequence). If we let n
of equation 2.5 go to infinity, so that the annuity becomes a perpetuity, then the

21

EXAMPLE 2.3

(2.6)

THE TIME VALUE OF MONEY

(1  r)n term goes to zero, and the present value of the perpetuity using the
equation becomes
B(, r)  1r

(2.7)

Thus, if r  0.10 and the series of cash receipts of $1.00 per period are infinitely
long, investors would pay $10.00 for the infinite series. They would not pay
$11.00, since they could invest that $11.00 elsewhere and earn $1.10 per period
at the going rate of interest, which is better than $1.00 per period. Investors would
like to obtain the investment for $9.00, but no rational issuer of the security would
commit to pay $1.00 per period in return for $9.00 when $10.00 could be
obtained from other lenders for the same commitment.
Although perpetuities are seldom a part of real-life problems, the calculations
of value are useful, since they allow us to determine the value of extreme
cases. For example, if r  0.10, we may not know the present value of
$1 per period for 50 time periods, but we do know that it is only a small amount
less than $10. The present value of a perpetuity of $1 per period is $10, and
50 years is close enough to being a perpetuity for us to use $10 as an approximate
value:
B(, r)  1r  1  $10
0.10
By comparison, the exact value is
B(50, .10)  $9.9148.

Intuitive interpretation
By rearranging the ordinary annuity equation, we obtain:
B(n, r)  1r  1r (1  r)n

(2.8)

On the right-hand side of equation (2.8), the first term is the present value
of a perpetuity. The second term, which is subtracted from the first, is the
product of two present values. One is the present value of a perpetuity, and
the second is the present value of $1 to be received in n years. Think of the
annuity as the difference between two perpetuities.The first perpetuity consists
of inflows beginning at the end of period 1. The second perpetuity consists of
outflows of the same absolute magnitude beginning at the end of period n  1.

22

THE TIME VALUE OF MONEY

The net result is that beginning in period (n  1) the inflows and the outflows
offset one another, and we have net cash flows of zero.The table below illustrates
the situation for n  3. The net cash flows are the sum of the inflows and the
outflows.
Period

Inflows
Outflows
Net cash flows

...

$1

$1

$1

$1

$1

$1

$1
$(1)
$

$1
$(1)
$

$1
$(1)
$

$1
$(1)
$

A flexible tool
We now have the tools to solve a wide range of time-value problems that have not
been described.While we could introduce other formulas, we prefer to adapt the
three basic formulas that have been introduced.
For example, if a $60-per-year annuity for 20 years were to have its first payment at time 10 and if the interest rate is 0.10, the present value is:
PV  XB(n, r)(1  r)t  $60B(20, 0.10)(1.10)9
 $60 (8.5136) (0.4241)  $216.64

XB(n, r)

60

60

10

11

...

...

Note that if the first annuity payment is at time 10 we only have to discount the
annuity for nine years to find the present value, since B(n, r) gives the annuity value
as of the end of period 9.

ANNUAL EQUIVALENT AMOUNTS


In many situations we want to determine the annual equivalent of a given sum. For
example, what is the annual equivalent over 20 years of $100,000 received today
if the time value of money is 10 percent?
The answer to this question lies in equation (2.6), which, when solved for the
annual cash flow, is
PV
X  B(n,
r)

(2.9)

23

THE TIME VALUE OF MONEY

EXAMPLE 2.4

That is, to find the annual equivalent X of a present sum PV, that sum is divided by
the annuity factor B(n, r), where r is the time value of money and n is the number
of years over which the annual equivalent is to be determined.
Calculations of this type are particularly useful in the management of financial
institutions such as insurance companies or banks, where customers make periodic
payments over an extended time period in return for a lump-sum immediate loan.
The ABC Company wishes to borrow $10,000 from the City Bank, repayable in
three annual installments (the first one due one year from now). If the bank
charges 0.10 interest, what will be the annual payments?
From equation (2.9),
$10,000
X
B(3, 0.10)
$10,000
X
 $4,021
2.4869
and the loan amortization schedule is
(1)

(2)

(3)

(4)

(5)
 (2)  (3)  (4)
Time Beginning balance Interest 0.10 of (2) Payment Ending balance
0
$10,000
$1,000
$4,021 $6,979
1
6,979
698
4,021
3,656
2
3,656
366
4,021
0*
The loan amortization schedule starts with the initial amount owed. Column 3
shows the interest on the amount owed at the beginning of the period. Column 4
is the debt payment and column 5 shows the ending debt balance. The ending
debt balance is equal to the beginning debt balance plus the periods interest
less the debt payment.
The process is repeated for the life of the debt. If the present value of the debt
payments is equal to the initial beginning balance (as it will be using the effective
cost of debt), the ending balance after the last debt payment will be equal to zero.
*There is a $1 rounding error.

A GROWING ANNUITY
Assume that X1  D is received at time one. In each subsequent period the
amount received grows at a rate of g, so that at time two X2  (1  g)D is
received and at time three X3  (1  g)2D is received.
The present value (P) of this infinite series is
D
Pr
g

24

(2.10)