The net present value theory

Just as a borrower takes out a loan to generate some sort of benefit (in the case of a business, the benefit is typically a stream of revenue), so the lender considers the loan an investment. In exchange for making funds available to the borrower, the lender charges an interest rate; that interest rate is the lender's own cash flow. Banks charge interest rates to their borrowers, and pay interest rates to their depositors (from whom the banks are essentially "borrowing" funds). Similarly, interest (coupons) are paid on corporate bonds. When considering investments of this type, decision makers typically take into account the interest rate that they will be earning on their funds. Over time, this rate of return provides a gauge by which investments can be measured.

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red to make their financial statements public. Some of the areas which is often scrutinized are those of the ratio of liabilities to equity, liabilities to sales, liabilities to assets and current liabilities to current assets. The Modigliani-Miller Theorem No. 1 assumes that the total return of a company is unaffected by whether it borrows the funds to support that return or issues equity. The theorem also supposes that investors can borrow on the same terms as the firm by using their stock as security. The theorem then states that under these conditions, the financial structure decisions do not affect value (Milgrom and Roberts 458). This theorem has interesting consequences since it goes against the common idea that from a financial standpoint, borrowing is not good for a company (or an individual). When investors analyze companies, they look at the amount of debt that is outstanding and can raise concern if the debt level seems high. But a return to the accounting equation, that assets are equal to liabilities plus equity (Ross, Westerfield and Jordan 14) suggests that the theorem does not, in fact, run counter to business practice. The accounting equation does not care whether the assets are funded by debt or equity; b
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Approximate Word count = 3104
Approximate Pages = 12 (250 words per page)

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