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cacc 706_ch 02 - Relevant Information Information about the...

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Relevant Information: Information about the firm’s future economic prospects (re: dividends, CF, and profitability) When is relevant information reliable? Reliable information faithfully represents without bias what it is intended to represent THE PRESENT VALUE MODEL UNDER CERTAINTY By“ certainty ” we mean that the future cash flows of the firm and the interest rate in the economy are publicly known with certainty. We denote these as ideal conditions . Example 2.1 – PV Model under Certainty: Consider P.V. Ltd, a one-asset firm with no liabilities Assumptions: Asset will generate end-of-year CF of $150/year for 2-years and then will have zero value Risk-free interest rate in the economy is 10% At time = 0 Present value of firm’s future CF (PA 0 ) = + = $260.33 Present value opening balance sheet: Since future net revenues are capitalized into asset value, net income is simply interest on opening asset value, just as income from a savings account is interest on the opening account balance Thus, NI = (opening PA 0 × interest rate) = $260.33 × 10% = $26.03 (=accretion of discount) Firm’s income statement for year 1: At time = 1 Present value of the remaining cash flows from the firm’s asset (PA 1 ) = = $136.36 Assuming that the firm pays no dividend, the following is the year-end balance sheet:
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Dividend can be incorporated by reducing cash and shareholders’ equity by the amt of the dividend Note the following points about Example 2.1: 1. Year-end Net Book Value = Present Value (value-in-use) 2. Time = 0 Accretion of discount is also called ex ante/expected NI since, at time 0, the firm expects to earn $26.03 Since all conditions are know with certainty, expected NI = ex post or realized NI 3. The information in Example 2.1 is entirely relevant . To see this, note first that, fundamentally, economic prospects are defined by the firm’s stream of future dividend (it is dividends that provide a payoff to investors, the present value of which serves to establish firm value). Will timing of dividends and the firm’s dividend policy affect its present value? No. Not under ideal conditions and dividend irrelevancy. Under ideal conditions: Investors can invest any dividends they receive at the same rate of return as the firm earns on cash flows not paid in dividends The PV of an investor’s overall interest in the firm is independent of the timing of dividends In effect, the firm’s cash flows establish the size of the “pot” that is ultimately available to investors and it does not matter if this pot is distributed sooner or later. If it is distributed: during the current year, investors can earn 10% on the distributions in a subsequent year, the firm earns 10% on amounts not distributed, but this accrues to investors through an increase in the value of their investment (PV to the investor is the same either way) Under dividend irrelevancy, cash flows are just as relevant as dividends, because cash flows establish the firm’s dividend-paying ability. As a result, the financial statements under Example 2.1 are entirely relevant.
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