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GLOBAL FINANCIAL MANAGEMENT

GLOBAL FINANCIAL MANAGEMENT. UNIT 4: Advanced Topics in Valuation. TouchText. Discounting Finite Future Cash Flows Discounting Infinite Future Cash Flows Combining PF Formulas. Problems and Exercises. Next. Finite Cash Flows.

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GLOBAL FINANCIAL MANAGEMENT

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  1. GLOBAL FINANCIAL MANAGEMENT UNIT 4: Advanced Topics in Valuation TouchText • Discounting Finite Future Cash Flows • Discounting Infinite Future Cash Flows • Combining PF Formulas Problems and Exercises Next

  2. Finite Cash Flows Capital Investment Projects typically have a finite life of “T” cash flows. The general formula for valuing a finite number of future cash flows is: Dictionary This formula can be re-written as: The terms in brackets [ * ] are known as “discount factors”. They can be looked up on a discount factor table. Take Notes Back Next

  3. Reading the Discount Factor Table Example: Cash flow in year 6; r = 8%. Discount Factor = 0.6302 Dictionary Take Notes Back Next

  4. Finite Cash Flows: Start at Period 1 Example: Find the PV of: C1 = $500; C2= $600; C3= $700; r = 12% Dictionary Take Notes Back Next

  5. Finite Cash Flows: Start at Period 5 Example: Find the PV of: C5 = $500; C6= $600; C7= $700; r = 12% Dictionary Take Notes Back Next

  6. Special Finite Cash Flows: Annuities When every future cash flow has the same value, the cash flow stream is called an Annuity, and its PV formula simplifies to: Dictionary Annuity: C1 = C2 = C3 = ……. = CT The term in brackets [ * ] is known as an “annuity factor”. Its value can be looked up on an annuity factor table. Warning! This formula gives the “PV” exactly one time period before the first cash flow. So, if the first cash flow does not happen in exactly on time period, the annuity PV will have to be adjusted. Take Notes Back Next

  7. Valuing Annuities: Start Time Period 1 Annuity: C1 = C2 = C3 = ……. = C10 = $400, r = 9% Dictionary Warning! This formula gives the “PV” exactly one time period before the first cash flow. So, if the first cash flow does not happen in exactly on time period, the annuity PV will have to be adjusted. Take Notes Back Next

  8. Reading the Annuity Factor Table Example: Annuity for 10 years, r = 6%. Annuity Factor = 7.3601 Dictionary Take Notes Back Next

  9. Valuing Annuities: Start Time Period 7 Annuity: C7 = C8 = C9 = ……. = C16 = $400, r = 9% Step 1: Dictionary Step 1: Get the value of the annuity exactly one period before the first cash flow; Step 2: Discount the future annuity value back to the present. Step 2: Take Notes Back Next

  10. Steps 1 and 2: Visually When using a special PV formula – such as that for an annuity – one often needs to undertake a 2-step process to calculate today’s PV. Dictionary Step 1: Value the annuity exactly 1 period before the first cash flow. Step 2: Discount the future value of the annuity back to the present. Take Notes Back Next

  11. Infinite Cash Flows: (Growing) Perpetuities Business are assumed to live forever, So we cannot use the previous formulas. When valuing businesses, at some point we will need an infinite cash flow model. The only one available is the Growing Perpetuity model: Dictionary Growing Perpetuity: Cash flows grow by g% each period forever: C1, C2 = C1 * (1+g), C3 = C2 * (1 + g), C4= C3* (1 + g), ORC1, C2 = C1 * (1+ g), C3 = C1* (1+g)2, C4 = C1 * (1 + g)3, etc. If the growth rate g = 0%, we have a simple Perpetuity. Its formula simplifies to PV = C/r. Take Notes Back Next

  12. Perpetuity: PV Calculation What is the PV of a perpetuity, whose first cash flow of $400 is in period 1? The discount rate r = 10%. Dictionary What is the PV of a perpetuity, whose first cash flow of $400 is in period 10? The discount rate r = 10%. Just as with the perpetuity formula, the perpetuity PV formula must be used in a 2-step process, when the first cash flow does not happen exactly at period 1. Take Notes Back Next

  13. Steps 1 and 2: Visually When using a special PV formula – such as that for a perpetuity– one often needs to undertake a 2-step process to calculate today’s PV. Dictionary Step 1: Value the perpetuity exactly 1 period before the first cash flow. Step 2: Discount the future value of the perpetuity back to the present. Take Notes Back Next

  14. Combining PV Formulas Future cash flows can often be separated into sections or pieces, which are valued separately. Then, they are added together to get the PV of the entire cash flow stream. Dictionary Example: What is the PV of $250 each period for the next 8 periods, and then $200 each period thereafter, forever? r = 8%. Annuity Perpetuity starting in year 9 Take Notes Back Next

  15. Combining PV Formulas: Solution Dictionary Take Notes Back Next

  16. End of Unit 3 Questions and Problems Dictionary Take Notes Back Next

  17. Dictionary Take Notes Back Next

  18. End of Unit 4 Questions and Problems The following problems require the calculation of various statistics using MS Excel. The problems are linked to actual Excel spreadsheets, where students should do their work. Dictionary Take Notes Back Next

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