First basic financial principle: 1 USD now is worth more than 1 later
The PV rule, invented by the American economist Fisher in 1930, permits to compare 1 USD now and 1 later.
To do that, we multiply the future pay-off by a discount factor 1/1+r
Ex: 1 FRF in 1 year is 1/1+r, 1/(1+r)2 in 2 years, etc.
To explain that, if you have 0,91 FRF now and you leave it on your bank account and receive an interest of 10 %, you get in 1 year 0,91 + (0,91*10 %) = 1 FRF. So 1 FRF in one year is worth 0,91 FRF now. The same apply for n years.
The PV is the normal price for both the buyer and the seller. So it is the market price.
Here r is called the discount rate, hurdle rate or opportunity cost of capital. What we call NPV is the PV-what we have to pay for the investment.
2nd basic financial principle: a safe USD is worth more than a risky one
Calculated this way, the NPV is not enough to tell us if a investment is worth taking.
We have to take risk into account. So we have to add a premium for the risk. The expected return must be higher otherwise normal people would choose the less risky investment.
Ex: First choice: you give 100 XEU and you have a probability of 0.5 to get in 1 year 120 XEU and 0.5 to stay at 100 XEU.
Second choice: you give 100 XEU and you get in 1 year 110 XEU, without risk
It is the same NPV, but everyone or almost everyone would like to choose the second one. Therefore, if the project is risky, we have to calculate the NPV with a hurdle rate that take this risk into account.
The only way is to choose the expected return of stocks with the same risk. For example, in France Treasury bills give 3 % with no risk and, at the opposite, risky stocks are expected to give 15 % on average but that means that it could be a loss or a bigger % of gain.
How to calculate present value >> |
|
Corporate finance
The subject: corporate finance
PART ONE: CAPITAL EXPENDITURE
The present value
Investment
decisions
Practical
problems in capital budgeting
Firms evaluation
PART TWO. BASICS OF FINANCE
The financial
markets
Options
The market
efficiency
Risk
Mergers,
Acquisitions, and Corporate Control
International
Financial Management
PART THREE FINANCING DECISIONS
Corporate
financing
Dividend policy
and capital structure
PART FOUR FINANCIAL MANAGEMENT
Financial
planning
Short-term
financial management
Courses created and updated by Dr David Chelly, PhD in Management sciences from the University of Tours.
|