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ACC_411_Key_Concepts_Relationships

ACC_411_Key_Concepts_Relationships - KeyConcepts...

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Key Concepts &  Relationships q You need to commit these to  memory, NOW!  Hopefully,  they are all familiar. 1 Key Concepts and Relationships
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Net Present Value Concept n Future cash flows are converted into their equivalent value in today’s dollars by the Discounted Cash Flow (Net Present Value concept) formula q The further cash flows are in the future the less they are worth in today’s dollars q The less certain the future cash flows (more risky), the less they are worth in today’s dollars 2 Key Concepts and Relationships
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Discounted Cash Flow Model  (Returns = Return on Investment, Free Cash Flows,  Dividends, Interest…. the value of any future returns  you receive or pay) t 1 rate) Discount 1 ( Returns Value + = = t n t t 3 Key Concepts and Relationships
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Discount Rate q The cash flows being discounted are our best estimate of the future cash flows (expected values), but obviously the future is always uncertain q The discount rate varies with the level of uncertainty (riskiness) of the future cash flows n Higher risk = higher discount rate n Lower risk = lower discount rate q Therefore, identical expected cash flows will have different NPVs that depend on their expected riskiness 4 Key Concepts and Relationships
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Valuing a Company n In finance, we value all assets and liabilities at the NPV of the future net cash flows they are expected to produce n Therefore, the direct economic value of a company is measured by the NPV of the expected future, net “free cash flows” produced by the company q More relevant to us, the cash flows associated with our fractional share of the company, e.g., share of common stock owned 5 Key Concepts and Relationships
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Discounting Free Cash Flows that are  Growing at a Constant Rate n This simplifying formula helps us see the impact of risk (r) and growth (g) on the future cash flows Value0 (NVP) = Cash Flowt (1+g) / (r-g) or Value0 (NVP) = Cash Flowt+1 (1 / (r-g) n r = discount rate, i.e., the cost of capital n g = growth rate of Returns (g<r; g can be negative) 6 Key Concepts and Relationships
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Cost of Capital:  The appropriate discount 
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