Harold Bierman, Jr. And Seymour Smidt THE CAPITAL Tasa Interna de Retorno y Valoración de Proyectos

© All Rights Reserved

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Harold Bierman, Jr. And Seymour Smidt THE CAPITAL Tasa Interna de Retorno y Valoración de Proyectos

© All Rights Reserved

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Vous êtes sur la page 1sur 42

Ninth edition

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:

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

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: 9780415400046 (pbk)

Contents

List of illustrations

Preface

Extracts from the preface to the first edition

xiii

xvii

xix

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

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

32

32

35

36

36

36

37

43

43

43

44

44

46

48

53

54

55

60

61

63

64

73

74

75

75

83

83

84

85

86

87

87

88

91

91

92

93

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 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

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

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

152

153

153

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

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

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

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

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

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

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

319

320

321

323

324

326

327

327

328

329

330

331

332

332

What is inflation?

Real cash flows

Real cash flows and nominal flows

334

334

335

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

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

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

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

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

14

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

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

167

175

196

208

251

252

255

278

280

284

284

337

339

339

340

341

341

346

359

365

380

384

xv

Preface

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

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

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

corporate objectives

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

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

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:

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.

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

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.

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.

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.

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.

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.

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

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.

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.

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

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.

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.

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

decisions of the firm and its ultimate competitive position involves strategic decisions

(it also may be an application of option theory).

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 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

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.

3

4

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

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

theory.

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

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 (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

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

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

equivalent of a present amount.

Symbols used

X

Xt

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

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

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)

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.

14

value is doubled

0.02

0.05

0.10

0.15

0.20

35.0 years

14.2

7.3

5.0

3.8

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

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)

1

PVF(n, r) FVF(n,

r)

and

1 .

FVF(n, r) PVF(n,

r)

There are three common methods for finding present value factors: tables, hand

calculators, and personal computers.

16

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.

HEWLETT-PACKARD 12C CALCULATOR

keystrokes used are different from those used in most other hand

calculators.

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.

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

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.)

SPREADSHEET PROGRAM

Hint 1

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.

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.

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

EXAMPLE 2.2

$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

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.

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.

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

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

B(3, 0.10) 2.4869

Using equation (2.5),

B(3, 0.10)

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)

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.

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)

(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 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.

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

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)

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