3-18
o
I
0
I
0
P
T
P

Two Terminal Investments: A Bond and a Project
A Bond:
1
2
3
4
5
0
Periodic cash coupon
Cash at redemption
Purchase price
Time, t
100
100
100
100
100
(1079.85)
1000
A Project:
Periodic flow
Salvage value
Initial investment
Time, t
1
2
3
4
5
0
460
460
380
250
430
(1200)
120
3-19

The Valuation Model: Bonds
r
D
is (one plus) the required return on the debt
Valuation issue
: What is the Discount rate
r
D ?
3-20
Required return: 8%
Year
Coupon
Redemp.
Discount
Present Value
1
100
0
0.926
92.59
2
100
0
0.857
85.73
3
100
0
0.794
79.38
4
100
0
0.735
73.50
5
100
1000
0.681
748.64
V
0
D
=
1079.85
T
T
D
T
3
D
3
2
D
2
D
1
D
0
F
C
F
C
F
C
F
C
V
r
r
r
r

The Valuation Model: A Project
r
P
is (one plus) the required return (hurdle rate) for the project
Valuation Issues:
How are cash flows forecasted?
What is the discount rate?
3-21
Required return:
12%
Year
Cash Flow
Discount
Present Value
1
430
0.893
383.93
2
460
0.797
366.71
3
460
0.712
327.41
4
380
0.636
241.50
5
370
0.567
209.95
V
0
p
=
1529.49
T
p
T
3
p
3
2
p
2
p
1
p
0
F
C
F
C
F
C
F
C
V
r
r
r
r

Value Creation: V
0
> I
0
•
The Bond (no value created):
V
0
=
1,079.85
I
0
=
1,079.85
NPV
=
0.00
•
The Project (value created):
V
0
=
1,529.50
I
0
=
1,200.00
NPV
=
329.50
3-22

Valuation Models: Going Concerns
CF
1
CF
2
CF
3
CF
4
CF
5
A Firm
1
2
3
4
5
0
d
1
d
2
d
3
d
4
d
5
Dividend
Flow
1
2
3
4
5
0
TV
T
T
d
T
Equity
The terminal value, TV
T
is the price payoff, P
T
when the share is sold
Valuation issues :
The forecast target: dividends, cash flow, earnings?
The time horizon: T = 5, 10,
?
The terminal value?
The discount rate?
3-23

4-24
The Dividend Discount Model:
Forecasting Dividends
Dividend Discount Model (DDM):
DDM with a terminal value:
A problem: The
dividend irrelevancy concept
•
Dividend policy can be arbitrary and
not linked to value added
•
Dividends paid before T reduce P
T
to leave the present value unaffected
Think of a firm (e.g. Facebook) that “pays no dividends”
The
dividend conundrum
:
Equity value is based on future dividends, but forecasting dividends over finite horizons does not give an indication of
this value
Conclusion: Focus on creation of wealth rather than distribution of wealth.
V
d
d
d
E
E
E
E
0
1
2
2
3
3
r
r
r
T
E
T
T
E
T
3
E
3
2
E
2
E
1
E
0
ρ
P
ρ
d
ρ
d
ρ
d
ρ
d
V

4-25
Terminal Values for the DDM
A.
Capitalize expected terminal dividends (perpetuity)
A perpetuity is a constant stream that continues without end. The periodic payoff in the stream is sometimes referred to as
an annuity, so a perpetuity is an annuity that continues forever. To value that stream, one capitalizes the constant amount
expected. If the dividend expected next year is expected to be a perpetuity, the value of the dividend stream is
where
= required cost of equity
B. Capitalize expected terminal dividends with growth
If an amount is forecasted to grow at a constant rate, its value can be calculated by capitalizing the amount at the required
return adjusted for the growth rate:
Terminal Values for DDM
1
d
T
E
1
T
T
r
T
P
V
g
P
V
E
1
T
T
d
T
T
r
E
r

Dividend Discount Analysis: Advantages and Disadvantages
Advantages
•
Easy concept:
dividends are what
shareholders get, so forecast them
•
Predictability:
dividends are
usually fairly stable in the short
run so dividends are easy to
forecast (in the short run)
Disadvantages
•
Relevance:
dividends payout is not related to

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- Spring '17
- Net Present Value