Principles of Corporate Finance

How To Calculate Present Values

Richard A. Brealey Stewart C. Myers Franklin Allen

Slides by

Matthew Will & A. Gledson de Carvalho

McGraw Hill/Irwin

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

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Topics Covered
Valuing Long-Lived Assets PV Calculation Short Cuts Compound Interest Nominal and Real Rates of Interest (inflation) Examples

McGraw Hill/Irwin

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

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Present Value
Present Value Value today of a future cash flow. Discount Rate Interest rate used to compute present values of future cash flows. Discount Factor Present value of a $1 future payment.

McGraw Hill/Irwin

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

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Present Value
Present Value = PV
PV =
C1 (1 + r )

 1  =   × C1 1+ r 

PV = discount factor × C 1
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Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

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Valuing an Office Building
Step 1: Forecast cash flows Cost of building = C0 = 350 Sale price in Year 1 = C1 = 400 Step 2: Estimate opportunity cost of capital If equally risky investments offer a return of 7%, then Cost of capital = r = 7%

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Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

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Valuing an Office Building
Step 3: Discount future cash flows

PV = (1C1 ) = (1400 ) = 374 +r +.07
Step 4: Go ahead if PV of payoff exceeds investment

NPV = −350+ 374= 24
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Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

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Net Present Value
NPV = PV - required investment C1 1+ r

NPV = C0 +

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Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

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Risk and Present Value
Higher risk