From last classes . . . . What should be the goal of financial managers?What do we need to know to pursue goal?How can we assess progress towards that goal?What is a firm\'s market value? Market cap? How do we compute them?. Overview: Classes 3 to 6. Discounted present value: basic tool given pro

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Present Value: Calculations and Interpretation

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What is a firm’s market value? Market cap? How do we compute them?

Overview: Classes 3 to 6

Discounted present value: basic tool given projections of cash flows and discount rate

Present value and wealth creation

One and multi-period cash flows

Patterns in cash flows = formulas

Applications to valuation: bonds

Application to valuation: stocks

To be addressed later: projecting cash flows, choosing a discount rate

(Class 3 & 4)

(Class 5 & 6)

Determinants of Value

Cash, Time, Riskdetermine value

Present value analysis deals with the effect of time or timing on value

Cash flow estimation is the subject of the next part of the course (classes 5 to 8)

Risk is incorporated in the discount ratethat we discuss in Part 3 of the course

In discussing present value analysis now, we assume that cash flows and discount rates are given

Emphasis on Present Values

Chapter 4 raises a number of topics relevant to the calculation of present values:

Simple versus compound interest

Compounding interval

Continuous compounding

Future values

Calculation of number of periods of cash flows to achieve a given present or future value

We will not emphasize these issues, we concentrate on basic present value calculations

Present Value of Cash Flows

Calculation of present values is key technique to assign values

Present value calculations are applications or simplications of two basic formulas: PV of single cash flow = PV of multiple cash flows =

Calculation of Present Values

Examples / Applications

U. S. Treasury strip prices are examples of market determined discount factors for default-risk free cash flows

The structure of present value tables like those in the text (A.1 and A.2) are very straightforward

Time in discounting in in terms of periods, usually one year, but often shorter intervals

Compounding interval will affect present or future values

Present Value Calculations

Present values can be calculated using present value tables and paper, calculators and paper, routines programmed into calculators, and spreadsheets

All correct methods produce the same answers

There is often more than one way to calculate the answers using formulas or individual cash flows but, if correct, they are all mathematically equivalent

Example of Three Approaches

Present value of $1000 received at the end of each year for five years discounted at 10%

Three (at least) ways produce same answer:

(Using Appendix Table A.1)

(Using Appendix Table A.2)

(Using Perpetuity formula and Appendix Table A.1 discussed later)

Characteristics of Present Value

Present value calculations are non-linear in the discount rate and growth rates, means changes in present values are not proportional to changes in the discount rate

Changes in timing or patterns of growth must always be calculated, relying on intuition is dangerous

Terminology may be confusing: discount rate, discount factor, interest rate, cost of capital, opportunity cost, and yield all can mean the same thing in a calculation

Example of Dangers

Change discount rate in previous example to 20% from 10%, PV becomes $2,991, reduced to 78.9% of $3,791 at 10%, not half.

Change times to $1,000 for ten years at 10%, PV becomes $6,146, not double.

Delay first cash flow by one year, PV reduced by about 10%, or if by three years, PV reduced by about 25%, difference between delay of one or three years is not three times greater.

Meaning of Present Value and Equality of Present Values

Present Value of $1,000 for five years at 10 percent (Table A.2)

$3,790.80 is equivalent to $1,000 at the end of every year for five years at 10 percent

Future value of $3,790.80 at end of five years is $3,790.80x(1.10)5=$6,105.12

This is also future value of $1,000 for five years at 10 percent (see Table A.4)

Equivalence of Present Valueto Annual Cash Flows

Example of Future Value

Summary of PV/FV Examples

Present value is the amount that can replicatecash flows if discount rate is the future interest rate

Maximizing present values also maximizes future values if interest rates do not change (in this case, they are equivalent)

Present values and future values of different patterns of cash flows will differ from calculations using constant discount rate if interest-rates vary through time

Net Present Value

Net present value (NPV) is the difference between the present value of the future cash flows and the cost of acquiring the cash flows

In most examples, costs are immediate and are not discounted, while cash flows are in the future and must be discounted

More generally, costs and benefits may both be discounted if some costs occur in the future

Net present value is a measure of how much more something is worth than it costs, or a wealth increase, as we discuss and illustrate later

Positive Net Present Values

A positive net present value means that future cash flows represent earnings higher than the discount rate

Net present value represents the excess returns (returns above the discount or opportunity rate) represented by the future cash flows

Net present values represent value added relative to the opportunity rate

Seek Simplifying Patterns in Cash Flows for Short-cuts

Can always evaluate individual annual cash flows but this is cumbersome

Simplest pattern is constant cash flow each year --

First formula to memorize is

Cash flow

time

Useful Present Value Formulas

Perpetuity:

Growing Perpetuity:

Annuity:

Growing Annuity:

Simple Patterns in Cash Flows

Perpetuity = Preferred dividend

Growing perpetuity = Approximate cash flows from new products or stock earnings

Annuity = Retirement fund or car or mortgage loan payments

Growing annuity = Approximate cash flows from investment with limited life or lifetime earnings

Graphical Representations

Perpetuity:

Growing Perpetuity:

Cash Flow

0

Time

Cash Flow

0

Time

Graphical Representations

Annuity:

Growing Annuity:

Cash Flow

0

T

Time

Cash Flow

0

T

Time

Sources of Present Values

Present value of $1 perpetuity at 20% is $5

Present value of $1 annuity for five years at 20% is $2.99

Therefore, present values of $1 from years six to infinity at 20% is $5 minus $2.99 = $2.01 (less than half of $5)

Present value of perpetuity growing at 10% starting at $1 and at 20% is $10

Growing over infinite life is valued at $10 minus $5 or $5

Graphical Presentation of Four Present Value Formulas

E

D

C

Cash

Flow

A

B

T

time

0

Graphical representation of the four important formulas

Areas in graph represent parts of future cash flows - Perpetuity = A+B

Growing Perpetuity = A+B+C+D+E

Annuity = A

Growing Annuity = A+C

You can solve for value added by a piece of cash flows, for example cash flows after T, by subtracting A from A+B

Example: $1 growing at 10% Discounted at 20%

PV = $ 10.00

E = $ 3.23

D = 1.23

C = $ .54

$ 1

A =$ 2.99

B = $ 2.01

0

5

Present Value and Net PV (NPV)

Present values are calculations assuming expected cash flows and required discount rates

Each may differ for different analysts

Knowledge and skill about future cash flows

Assessment of risk and alternative investments

Net present value = Present value - cost

Contrast present value with intrinsic value, market value, under-valued and over-valued

Use of Present Value Formulas

Familiarity with PV formulas important

For example, what is future value of constant annual cash flow? Using annuityobtaining (see. p. 840)

Relations between present value formulas are really simple

Using PV Formulas to Find Rates

You can solve for r given PV, in simplest case of perpetuity r = C / PV

With a value for g and PV in growth formula, find r also easy and common in stock analysis (we will use later)

With annuities and other formulas you can also solve for r although the equations are non-linear requiring searches

Present Value and Wealth

Wealth = Present value of consumption

Wealth = Present value of cash income

DWealth = Change in value of consumption = Change in present value of cash income

DWealth => Increase in utility from consumption

DWealth = Net present value

Net present value > 0 => Wealth increased

Present Value and MVA/EVA (I)

Market value added is how much more assets are worth than they cost

MVA is in part the present value of returns above the opportunity rate on investments thus represents management’s ability to find investments better than alternatives

EVA represents the returns above the opportunity rate and is a measure of management’s superior investment strategy

Present Value and MVA/EVA (II)

Market values represent present value of expected future cash flows

If market value is above acquisition cost (MVA), management is expect to produce cash flows are above opportunity rate levels

Excess returns (EVA) can be from existing investments and future growth opportunities or growth options

Present Value Summary

Present values represent cash amounts that can reproduce a pattern of cash flows in the future given the discount rate

Two equal present values can represent different patterns of future cash flows

Future values and present values are equivalent measures of value given the discount rate

Net present values are measures of the increase in wealth representing increased utility from increases in present and future consumption

Present Value Analysis: Review

Objectives

Vocabulary

Problem Assignments

Relation to syllabus and requirements

Basic Steps to Valuation in Finance

Estimate cash flows (CASH, TIME)

Easy or hard depending on asset

Look for patterns in cash flows

Choose a discount rate (TIME, RISK)

Risk adjusted

Opportunity cost

Calculate present value and net present value

Valuation in Finance

Applies to all investment opportunities, including

investments in fixed plant and equipment

starting a new business

selling a line of business (spin-off)

buying an existing business

values of bonds and stocks

real estate investments

Used by financial managers, stock and bond analysts, real estate investors

For Next Classes

Read Chapter 5, 14 and 20

Do problems as assigned

Download or call or write for annual report, 10K, and proxy statement, and any other disclosures, for the group project firm

Bring Value Line Investment Survey and Standard and Poor’s reports for the company to class

Look for analysts’ reports and press coverage of the group firm