Chap 3. Net Present Value. Net Present Value. Net present value is the single most widely used tool for large investments made by corporations. Klammer reported a survey of over 100 large companies indicating that in 1959 only 19 percent used NPV techniques, but by 1970, 57 percent used them.
Net Present Value
In effect, his marginal rate of substitution is his subjective price of units of consumption tomorrow for units of consumption today.
He always requires extra units of consumption tomorrow in return for giving up a unit of consumption today.
He will decide to remain at point B, where he consumes
today and at the end of the period, and invests today.
Won’t they all choose different optimal consumption/production points because they all have different preferences for consumption over time, and therefore difference indifference curves? The answer is no.
It also provides him with the highest possible total utility, because he will produce the output at point B, then borrow against it at rate r to reach point C, a bundle of consumption with wealth .
Also, the same market line is tangent to the production opportunity set at point B.
Therefore, if he maximizes his wealth, and his total utility, he will choose to produce the combination at point B, then borrow to move to point C.
At point C, his marginal rate of substitution equals the slope of the market line, which in turn equals his marginal rate of transformation.
This separation principle means that the wealth-maximizing rule for investment is separate from any information about individual utility functions.
The shareholders receive $1,250 in year 5 but must pay $500 to bondholders.
Comparable securities in the capital markets to estimate the capital for our project.
The definition of free cash flows shows what the firm will earn after taxes assuming that it has no debt capital.
The effect of financial decisions is reflected in the cost of capital.
A project’s expected cash flows are $1,000, the risk-free rate is10 percent, the expected rate of return on the market is 17 percent, and the project’s beta is 1.5.
If it is an all-equity firm, then its present value is
NPV = PV – I = $829.88 - $800 = $29.88
This approach adjusts for risk by subtracting a penalty from expected cash flows to first obtain certainty-equivalent cash flows, then it discounts them at the risk-free rate.
$1,000 - $87.13 = $912.87