Finance

Created 8/30/1996
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Business Administration 130

Brealey and Myers, chapter 2: Present Value

http://www.j-bradford-delong.net/Intro_Finance/BAonethirty2.html

Begin with the concept of "present value"

Brealey and Myers begin their chapter 2 with a simple situation: an apartment building has burned down, leaving you with a check for $200,000 and a lot worth $50,000. You want to figure out what to do.

Your financial advisor sets forth three options:

Choice	Now	Next Year
Cash out:	$250,000	$0
Build new office building:	-$100,000	$400,000
Invest in stock market (at 12% expected return):	$0	$280,000

What should you do?

To make things worse, you own the building in company wi th three of your relatives:

• Anthony Aardvark wants cash now: the more cash now, the better; he does not care about what he gets next year, but he needs money now.
• Cornelia Crocodile is willing to wait for money, but doesn't want to lay out more than she already has invested in the property--doesn't want to "throw good money after bad"
• Esmerelda Emu is far-sighted and wants the most money possible next year.

Anthony states that he wants option 1--sell everything. Cornelia wants option 3--invest, but don't throw more money into the process. Esmerelda wants option 2.

Now the answer is going to be:

Choice	Net Present Value (12% Discount Rate)
Cash out	$250,000
Build	$257,143
Invest	$250,000

You should choose option B--build. Why?

Simplest answer: it is the best thing you can do with the money...

• Go short the stock market $100,000; use your receipts to fund the extra construction money you need; and thus find yourself with the expected payoff (0, $288,000)--clearly better than the (0, $280,000) of "invest"
• Alternatively, go short the stock market to the tune of $350,000; use your receipts to pay money to Anthony Aardvark and fund the new construction, and find yourself with the expected payoff ($250,000, $8,000)--clearly better than the ($250,000, 0) of Anthony Aardvark's choice
• Thus maximizing net present value (and dipping into the capital markets either long or short) allows you to have your cake and eat it too: produce any relative pattern of "consumption" cash flows you wish at the highest level.

So: First Principle: Opportunity cost: What else could you do with the money?

Second Principle: Open access to capital markets allows you to shape your consumption profile

Third Principle: Moving your possible consumption profile up and to the right is a good thing:

Fourth Principle: Well-functioning capital markets mean that all present-future consumption possibility profiles are parallel.

Fourth Principle: Net Present Value is where the interest-rate line hits the x-axis: how much you could get today if you mortgaged all the future cash flows from the project you are undertaking.

Thus maximizing NPV is the way to get your consumption-possibilities line as far out as possible.

Not that big a problem. But, as Brealey and Myers say, "having glimpsed the problems of imperfect markets, we shall, like an economist in a shipwreck, simply assume our life jacket and swim safely to shore.

1. A financial manager should act inthe interst of the firm's shareholders
2. Each shareholder wants three things:
4. To be as rich as possible: that is, maximize current wealth
5. To transform that current wealth into whatever time pattern of consumption is desired
6. To choose the risk characteristics of that consumption plan
7. But stockholders don't need your help--don't need the company's help, don't need the financial manager's help--to reach the best time pattern of consumption. They can do that on their own (provided they have access to capital markets). They don't need your help to reach the best risk pattern.
8. How then can you help?
9. By increasing the market value of each shareholder's stake--by seizing all investment opportunities that have a positive net present value.

Other corporate goals?

"Maximize profits"--which year's profits? How about trading off present for future profits? Which accountant?

Do real managers actually maximize net present value? Brealey and Myers are more sanguine about corporate control than I am; our system is not a great one...

Next time: rules of thumb for calculating net present values...

Finance

Created 8/30/1996
Go to Brad DeLong's Home Page

Associate Professor of Economics Brad De Long, 601 Evans
University of California at Berkeley; Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
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