Chapter 02 - How to Calculate Present Values

CHAPTER 2
Present Values, the Objectives of the Firm, and Corporate Governance

All numbers are in $ millions

3.75
3

1 1.6 2.6 4

The straight line represents shareholder’s and firm’s opportunities for lending and
borrowing , and the curved line represents a firm’s opportunities for investment. All
investments, savings, and borrowing are in the same riskclass. Suppose a firm is
created and raises 2.6 million in cash. Answer the following questions.

1. What is the interest rate in the economy? By what other names might we refer to
this interest rate?

2. How much should the company invest in order to make its shareholders
happiest?
Invest 1.0 to make investors happiest; maximizes NPV
3. How much will this investment be worth next year?
FV = 3.0
4. What is the average rate of return on this investment?
IRR, slope of line from between beginning and end points.
Beginning: (2.6,0) End: (1.6,3.0)

2-1
Chapter 02 - How to Calculate Present Values

5. What is the marginal rate of return on this invesmtne?

Return on last dollar invested; MRR= r = 25%
6. What is the PV of the firm’s investment? What is another name for this PV?
PV = cost + NPV
PV = 1.0 + 1.4
PV = 2.4
7. What is the NPV of this investment? What is another name for this NPV?
NPV = 1.4; instantaneous change in price upon announcement
8. What is the PV of the shareholder’s investment? What is another name of this
PV.
PV = 4.0; price
9. How much does the shareholder want to consume today and how much
tomorrow?
1.0 today; 3.75 tomorrow
10. How could the firm satisfy the shareholder’s spending preferences in time
periods today and next year?

11. Could the shareholder spend (consume) $3 million toady? If yes, then how much
will they have to spend next year? Show this on the gaph.
Yes; 1.25 next year
12. If the firm has a no dividend policy, could the shareholder’s preferences for
spending still be satisfied? How?

13. Use Shareholder and firm balance sheets to represent the answers to questions
2, thru 11.

2-2
Chapter 02 - How to Calculate Present Values

Chapter 2 Handout Problem #2

Draw a figure like the one in problem #1 representing the following situation:
1. A firm starts out with $10 million in cash.
2. The rate of interest is 10 percent
3. To maximize NPV the firm invests today $6 million in real assets. This leaves $4
million which can be paid out to the shareholders.
4. The NPV of the investment is $2 million.

Answer the following questions:

1. How much cash is the firm going to receive in year 1 from its investment?
FCF = $8.8 million
2. What is the marginal return from the firm’s investment?
MRR = r = 10%
3. Who inside the firm will calculate the marginal return on this investment? How?
Director of capital budgeting

2-3
Chapter 02 - How to Calculate Present Values

4. What is the value of the shareholder’s investment before the investment plan is
announced? What is the value after the announcement? How long does it take
for this value change to occur?
10; 12; instantaneously
5. Suppose shareholders want to spend $6 million today. How can they do this?
Borrow $6 million against the stock
6. If they spend $6 million today, how much will they have to spend next year?
$6.6 million
7. Could they plan to spend more today? Would it change their wealth. What is
their wealth?
Yes; no; $12 million

Quiz Questions

8. (NO SOLUTION ONLINE) Why would one expect managers to act in

shareholders’ interests? Give some reasons.

Shareholders are greedy and self-serving; they own the company and have the
power. Managers are greedy and self-serving and are given compensation when
doing things that please shareholders. This represents a good principal-agent
relationship.

Practice Questions

13. Norman Gerrymander has just received $1 million bequest. How should he invest
it? There are four alternatives.
a. Investment in one-year US government securities yielding 5%.
b. A loan to Norman’s nephew Gerald, who has for years aspired to open a
big Cajun restaurant n Duluth. Gerald had arranged a one-year bank loan for
$900,000 at 10%, but wants a $1 million loan from Norman at 9%.
c. Investment in the stock market. The expect return in 12%.
d. Investment in real estate, which Norman judges is about as risky as the
stock market. The opportunity a had would cost $1 million and is forecasted to be
worth 1.1 million after one year.

a. NPV = 0
b. Negative NPV
c. NPV=0
d. Negative NPB

2-4
Chapter 02 - How to Calculate Present Values

Don’t do B or D because these will only deplete wealth over the life of the
investment. A neither better nor worse than C in present value terms, so Norman
should invest based in either A or C based on his risk preferences.

14. Which answers in #13, with rate adjustments, are potential positive NPV
investments and which answers, with rate adjustments are zero potential positive
NPV investments. Why?

B and D are potential positive NPV investments with rate adjustments because
each of these investments are given in relation to a fair return for its given risk
class. For B, the bank’s loan at 10% is the fair return; loaning money to Gerald at
a rate above 10% will generate positive NPV. For D, the stock market return is
deemed fair at 12%; returns above 12% in real estate would generate positive
NPV.

A and C will always give NPV=0 with rate adjustments because these markets are
efficient. Positive NPV can’t be realized in these markets regardless how the rate
changes.

2-5