Chap 3 - Present Value Aswath Damodaran Aswath Damodaran 1 Intuition Behind Present Value n There are three reasons why a dollar tomorrow is worth

Info iconThis preview shows pages 1–8. Sign up to view the full content.

View Full Document Right Arrow Icon
Aswath Damodaran 1 Present Value Aswath Damodaran
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Aswath Damodaran 2 Intuition Behind Present Value n There are three reasons why a dollar tomorrow is worth less than a dollar today Individuals prefer present consumption to future consumption. To induce people to give up present consumption you have to offer them more in the future. When there is monetary inflation, the value of currency decreases over time. The greater the inflation, the greater the difference in value between a dollar today and a dollar tomorrow. If there is any uncertainty (risk) associated with the cash flow in the future, the less that cash flow will be valued. n Other things remaining equal, the value of cash flows in future time periods will decrease as the preference for current consumption increases. expected inflation increases. the uncertainty in the cash flow increases.
Background image of page 2
Aswath Damodaran 3 Discounting and Compounding The mechanism for factoring in these elements is the discount rate. Discount Rate: The discount rate is a rate at which present and future cash flows are traded off. It incorporates - (1) Preference for current consumption (Greater . ...Higher Discount Rate) (2) expected inflation (Higher inflation .... Higher Discount Rate) (3) the uncertainty in the future cash flows (Higher Risk. ...Higher Discount Rate) A higher discount rate will lead to a lower value for cash flows in the future. The discount rate is also an opportunity cost, since it captures the returns that an individual would have made on the next best opportunity. Discounting future cash flows converts them into cash flows in present value dollars. Just a discounting converts future cash flows into present cash flows, Compounding converts present cash flows into future cash flows.
Background image of page 3

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Aswath Damodaran 4 Present Value Principle 1 n Cash flows at different points in time cannot be compared and aggregated. All cash flows have to be brought to the same point in time, before comparisons and aggregations are made.
Background image of page 4
Aswath Damodaran 5 Cash Flow Types and Discounting Mechanics n There are five types of cash flows - simple cash flows, annuities, growing annuities perpetuities and growing perpetuities
Background image of page 5

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Aswath Damodaran 6 I.Simple Cash Flows n A simple cash flow is a single cash flow in a specified future time period. Cash Flow: CF t _______________________________________________| Time Period: t n The present value of this cash flow is- PV of Simple Cash Flow = CF t / (1+r) t n The future value of a cash flow is - FV of Simple Cash Flow = CF 0 (1+ r) t
Background image of page 6
Aswath Damodaran 7 Application 1: The power of compounding - Stocks, Bonds and Bills n Ibbotson and Sinquefield, in a study of returns on stocks and bonds between 1926-92 found that stocks on the average made 12.4%, treasury bonds made 5.2% and treasury bills made 3.6%. n
Background image of page 7

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Image of page 8
This is the end of the preview. Sign up to access the rest of the document.

This note was uploaded on 03/01/2012 for the course FINS 3641 taught by Professor Hyip during the Three '11 term at University of New South Wales.

Page1 / 37

Chap 3 - Present Value Aswath Damodaran Aswath Damodaran 1 Intuition Behind Present Value n There are three reasons why a dollar tomorrow is worth

This preview shows document pages 1 - 8. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online