Original painting expect to be able to sell the

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Unformatted text preview: h dividends of $300 per year indefinitely. Oil well Expect to receive cash flow of $2,000 at the end of year 1, $4,000 at the end of year 2, and $10,000 at the end of year 4, when the well is to be sold. Original painting Expect to be able to sell the painting in 5 years for $85,000. With these cash flow estimates, Celia has taken the first step toward placing a value on each of the assets. 282 PART 2 Important Financial Concepts Timing In addition to making cash flow estimates, we must know the timing of the cash flows.10 For example, Celia expects the cash flows of $2,000, $4,000, and $10,000 for the oil well to occur at the ends of years 1, 2, and 4, respectively. The combination of the cash flow and its timing fully defines the return expected from the asset. Risk and Required Return Hint The required rate of return is the result of investors being risk-averse. In order for the risk-averse investor to purchase a given asset, the investor must expect at least enough return to compensate for the asset’s perceived risk. EXAMPLE The level of risk associated with a given cash flow can significantly affect its value. In general, the greater the risk of (or the less certain) a cash flow, the lower its value. Greater risk can be incorporated into a valuation analysis by using a higher required return or discount rate. As in the previous chapter, the higher the risk, the greater the required return, and the lower the risk, the less the required return. Let’s return to Celia Sargent’s task of placing a value on Groton Corporation’s original painting and consider two scenarios. Scenario 1—Certainty A major art gallery has contracted to buy the painting for $85,000 at the end of 5 years. Because this is considered a certain situation, Celia views this asset as “money in the bank.” She thus would use the prevailing risk-free rate of 9% as the required return when calculating the value of the painting. Scenario 2—High Risk The values of original paintings by this artist have fluctuated widely over the past 10 years. Although Celia expects to be able to get $85,000 for t...
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