Created 8/30/1996
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Business Administration 130

Brealey and Myers, chapter 2: Present Value

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 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...

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.

Caveat: borrow and lend at the same rate--you must be able to choose to either a borrower or a lender be at the same rate. Problem of imperfect markets

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:
  3. To be as rich as possible: that is, maximize current wealth
  4. To transform that current wealth into whatever time pattern of consumption is desired
  5. To choose the risk characteristics of that consumption plan
  6. 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.
  7. How then can you help?
  8. 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...

Brief note on risk and net present value; time and uncertainty are both important; here we do time. Starting in chapter 7 we do uncertainty.

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


Created 8/30/1996
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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