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Ninth edition
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
Contents
List of illustrations
Preface
Extracts from the preface to the first edition
xiii
xvii
xix
1
2
3
4
4
4
5
6
6
7
7
8
8
9
10
10
11
11
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
113
113
114
116
116
118
119
119
120
121
122
122
125
125
126
127
133
134
135
136
141
141
142
144
145
148
148
148
150
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
180
181
182
183
186
187
187
190
192
192
194
195
197
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199
200
201
204
204
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
242
243
244
244
244
245
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261
262
263
264
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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
303
303
304
306
306
307
309
311
311
312
313
315
316
316
318
319
320
321
323
324
326
327
327
328
329
330
331
332
332
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
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
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
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
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
167
175
196
208
251
252
255
278
280
284
284
337
339
339
340
341
341
346
359
365
380
384
xv
Preface
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
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
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:
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.
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.
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.
decisions of the firm and its ultimate competitive position involves strategic decisions
(it also may be an application of option theory).
3
4
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.
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
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
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
Summation symbol as in
(1 r)t
(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
(2.2)
14
0.02
0.05
0.10
0.15
0.20
35.0 years
14.2
7.3
5.0
3.8
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)
and
1 .
FVF(n, r) PVF(n,
r)
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.
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.)
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.
19
EXAMPLE 2.1
EXAMPLE 2.2
Cash flow Xt
1
2
$100
200
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.
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
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)
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.
(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)