3 18 o I I P T P Two Terminal Investments A Bond and a Project A Bond 1 2 3 4 5

3 18 o i i p t p two terminal investments a bond and

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3-18 o I 0 I 0 P T P
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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
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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
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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
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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
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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
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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
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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
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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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