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ECON 201 Summer 2009. Finance: Net Present Value 8.1. Firm’s Financing Decision. Firm’s desire to expand and purchase new capital stock can be financed by: Loan (repay with interest) Borrow $X from a lending institution (bank) Issue bonds (debt)
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ECON 201 Summer 2009 Finance:Net Present Value8.1
Firm’s Financing Decision • Firm’s desire to expand and purchase new capital stock can be financed by: • Loan (repay with interest) • Borrow $X from a lending institution (bank) • Issue bonds (debt) • Promise to pay back bond holders later for obtaining $X today • Sell stock (corporate holdings, stock splits) • Decrease stock price in the short-run • Venture Capital
Benefit/Cost Analysis • Basic Issue in Business or Personal Finance Decisions • How to evaluate projects/investment opportunities that have a flow of benefits and costs over time • Approach • Stream of benefits and costs are discounted over time (Net Present Value) • Accounts for opportunity costs of money • Time rate of preference
Why Firms Seek Funds • The most common reason for firms to seek funds (financial capital) is to pay for plant and equipment (physical capital).
The Net Benefits from an Investment • The net benefit of an investment project is the difference between the revenue generated by the project and the project’s cost, including opportunity cost.
Interest • Interest is an important part of the investment decision for two reasons: • First, interest must be paid to borrow funds. • Second, interest is the opportunity cost of using money to pay for an investment project. • Money used to purchase capital could have been deposited in a bank to earn interest.
Interest (cont’d) • Lenders charge interest: • To compensate themselves for not being able to use their own money to buy the things they want • To compensate themselves for the risk they assume when they make a loan • Because rising prices will reduce the purchasing power of the money when it is repaid
Time Value of Money • Money today is more valuable than the same amount of money at some point in the future. • If you have money today, you could deposit it in a bank and earn interest.
Present and Future Value • The present value (PV) of money received in the future is equal to its value today. • In other words, it is the maximum amount that someone would pay today to receive the money in the future.
Present and Future Value (cont’d) • The future value (FV) of money is what an amount of money will be worth at some point in the future.
Present and Future Value (cont’d) • The relationship between present and future value can be shown by the following equations:
Present and Future Value (cont’d) • Examples: Suppose the interest rate is 5%. • What is the future value of $10,000 one year from now? • FV = $10,000 x (1 +.05) = $10,500 • What is the present value of $10,000 received one year from now? • PV = $10,000 / (1 +.05) = $9,524
Present and Future Value (cont’d) • Discounting refers to the method used to calculate the present value of a stream of payments over time. • Example: Suppose a firm expects to earn $10,000 of revenue in each of the next 2 years.
Evaluating Projects • Expansion project • Requires an initial investment, Io • Yields a flow of benefits over time, Bt
Net Present Value • Firms focus on the net present value(NPV) of an asset when making investment decisions. • NPV = PV of the asset minus the PV of the expenditures on the asset. • If NPV > 0 then the investment is profitable. • All else equal, the sooner the benefits are received and the lower the interest rate, the higher the NPV.
Net Present Value (cont’d) • Example: Suppose a firm is considering investing $8,000 in new equipment. As a result of the new equipment, the firm expects to earn revenues of $10,000 in each of the next 2 years. • Since NPV is positive, the firm should undertake the investment.
Interest and the Demand for Capital • The interest rate represents the opportunity cost of purchasing capital. Therefore, as the interest rate increases, the quantity of capital demanded will fall.
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