Ch3Financial market and Net present value (NPV)(澳大利亚新英格兰大学公司金融课件)

Consider an investment that costs K in period 1 and returns R in period 2. If undertaken, the investment will move the initial endowment point.
y1 , y2 y1 K , y2 R
c2
y2 y1 1 r
y2
y1
y1
y2 1 r
c1
• This test does not depend on individual preferences and investment and consumption saving decisions can be separated (the separation theorem)
Chapter 6
Some alternative investment rules
Payback rule, Accounting rate of return, IRR
Chapter 7
NPV and capital budgeting
how to estimate cash flows required for capital budgeting incremental cash flows
Hence the investment is worthwhile if (***) > 0 , which implies
R 1 r K

Future value (FV) rule : Present va lue (PV) rule :
R 1 r K
R K 1 r R Net present va lue (NPV) rule : K 0 1 r
c 1 ,c 2 y1 ,y 2
b
1. Inter-temporal consumption opportunities 2. Inter-temporal indifference curves 3. Effect of interest rate increases 4. First principle of investment decision-making 5. Net present value rule
max b
y2 1 r
y2
lending
y2 max c1 y1 b y1 1 r max c2 y2 y1 1 r
borrowing
y1
y2 y1 1 r
c1
Inter-temporal indifference curves
Budget constraint :
1 r c1 c2 1 r y1 y2 0 Substituting c1,c 2 y1-K,y 2 R to the budget constraint gives 1 r y1 K y2 R 1 r y1 y 2 (***)
[Part II]
Chapter 3
Value and Capital Budgeting
Financial market and Net present value (NPV)
basic principles of rational decision making two period investment NPV introduced as investment decision making rule - first principle of investment decision making
Financial Markets and Net Present Value (NPV)
Financial markets and NPV
Consumption choices over 2 periods Period 1, 2
Consumption Incomes Borrowing in period 1
Chapter 4 Net present Value
extend NPV to multiple periods compounding and discounting
Chapter 5
How to value bonds and stocks
apply NPV to value bonds, stocks and other financial instruments
y2
y1
c1
First principle of investment decision making
An investment is worth taking if it is at least as desirable as what is already available in the financial markets • A new investment opportunity will be worthwhile if and only if it moves the initial endowment point outside the budget set
Chapter 8 Strategy and analysis in using NPV
assess reliability of the estimates of NPV techniques dealing with uncertain incremental cash flows
Lecture 3
c2
Choice of patient individual
பைடு நூலகம்
c2
Increasing utility
C
y2
D
Choice of impatient individual
y1
c1
c1
Effect of Interest rate increases
c2
C* C D D*
c1 becomes relatively more expensive. c1 will decline and saving will increase.
Inter-temporal consumption opportunities
: consumption smoothing possible due to financial markets
c2
y2 y1 1 r
Budget constraint
slope 1 r
Net Present Value Rule
An investment is worth making if it has positive NPV. If the investment’s NPV is negative, it should be rejected. NPV rule is independent of investor preferences and endowments. The desirability of an investment is determined by its cost and return, and the market rate of interest. Shareholders will all want to accept or reject the same investment projects according to the NPV rule, regardless of their preferences and endowments. Hence, owners can delegate firm operations and require managers to use the NPV rule to maximize company present value.
Examples :
The Balsam company’s only asset is $100,000 cash in the bank collecting 20% interest. Balsam has an investment opportunity that will cost $30,000 and will produce a NPV of $7,500. If Balsam invests, what is the new value of the firm? 100,000 + 7,500 = 107,500
borrowers are worse off lenders are better off Note ! Price-taking assumption used. [Conditions of perfectly competitive financial markets] – costless trading – information available – many insignificant traders
Examples :
An investor’s income is $100,000 this year and $120,000 next year. She plans to spend $80,000 this year and $143,200 next year. If the difference between her income and consumption patterns results from a financial market transaction, what is the market interest rate? (Saving this year) = $100,000 - $ 800,000 = $20,000 (Return on saving next year) = 20,000/(1+r) = 23,200 r = 0.16 An investment in real assets requires an initial outlay of $2 million. It promises to pay $2.18 million in one year. The market interest rate is 10%. Is this a good investment? No , since return from investing in financial market is 2(1+r) = 2(1.1) = 2.2 > 2.18 What is the rate of return on this project? r’ = (2.18 -2)/2 = 0.09 < 0.10
If Balsam invests, what will be its value next year?
107,500(1+0.2) = 129,000 = 70,000(1.2) + 37,500(1.2) = 100,000(1.2) + 7,500(1.2)
A new firm has 0 initial endowment, so a positive NPV project appears as R
Slope = -(1+r)
-K
NPV
Separation theorem can be derived also for risky cash flows over many periods.
An increase in the interest rate r will imply that fewer investments will have a positive NPV. Hence, the demand for loans from firms is a downward sloping function of r. Equilibrium rate is determined by demand and supply of loans in capital market.