All right.

So let's drop into general finance and

do a very simple example, taken from general finance.

So let's say our investment mission is, we buy short term bonds with

strong anti-default guarantees, strong guarantees against default.

So we would, first thing we would do is go out into the marketplace and say

given that this is our mission in life, what's our opportunity cost of capital?

So we go out and we find that as 5%.

And actually the chapter appendix, which I'm not going to cover, but

which is in the slides here, does show how we could come up with this specifically.

So we know our mission in life, our investing mission in life.

We know our corresponding opportunity cost of capital and now we're looking for

projects to invest in, and along comes DistressedSeller, and

DistressedSeller offers us this deal.

Okay, he says, I've got a bond to sell you.

It matures in one year, that means the bond contract is

over in one year and the bond contract says that in a year

whoever owns this bond is going to be paid $110 and

the asking price DistressedSeller wants us to pay right

now $10 for this bond and it's a treasury bond, okay.

So, do we want to buy this bond?

Let's apply the NPV methodology and see what's happening here, okay?

So here up at the top is once again our NPV formula.

We know our investment mission, we know our opportunity cost of capital.

We invest in very short term stuff with strong guarantees,

pretty much not much is stronger, guarantee wise, than Treasuries.

DistressedSeller is offering us a Treasury, so that's good and

this is in the appendix.

That's a little hint about how we came up with our opportunity cost of capital.

And let's see what we can do with this.

We're just kind of apply the formula directly here, okay?

So the NPV is going to be equal to our

first cashflow, is -100 over

1.05 to the 0.

Plus everything is algebraic, great, in this here.

Plus the 110 so that 100 is negative because that's our

cash flow at time equals 0 to buy the bond and

this is 1.05

raised to the 1 where here I've just applied,

all I've done here is just expanded and applied this formula directly.

Okay?

And if you go ahead and solve that,

you get here $4.76.

Is that less than zero?

Yeah. I think in most circles $4.76 is more

than zero, so that means we should go ahead and buy the bond.

So that's how it works.

The details get more complicated when you have 20 years worth of cash flows.

And you're just going to find that you have more terms in the formula here,

but in principle, that's pretty much all there is to it.

Okay, there are some interesting interpretations of this result.

Again, in gray you can look at them if you want.

They're in detail in the text if you want to look that up,

equivalence concept is kind of interesting, but

we don't have time for this in this introductory course.

Net Present Value (NPV) Examples

Construction Finance

Meet the Instructors