1.2 Cashflows and present value Flashcards
How do we value firms?
Each asset is defined by its cashflow stream
Value of the asset is the sum of the cashflows
The value of a firm is the sum of its assets
What are the key considerations of cashflows?
Time (time value of money)
Risk (risk premium)
Role of time in valuing cashflows
Money today is (generally) preferable to money tomorrow.
Effects of inflation and flexibility.
Role of risk in valuing cashflows
Money with certainty is (generally) preferable to money with uncertainty.
People are (generally) risk averse and prefer certainty.
How can we represent cashflows?
Define opportunity cost of capital
The expected return offered by an alternative, equivalent (in time and risk) investments in financial markets.
Basic formula for net present value
Net Present Value = Cashflow₀ + Cashflow₁
What is the value of project A?
Assume risk-free and 5% annual interest rate.
What is the value of project B?
Assume mild risk, 6% annual interest rate.
What is the value of project C?
Assume highest level of risk, 15% annual interest rate.
What is shareholder unanimity?
When all shareholders agree unanimously about an investment decision.
Assuming a company has three shareholders: Grandma, Mother and Daughter.
- Grandma: highly risk averse and very impatient.
- Mother: favours safe safe investment that pays off later.
- Daughter is myopic and does not care about risk, caring only about cashflows.
Can they agree on a single project? If so, which?
They should agree to the highest NPV project (B).
In a market with complete and perfect markets, the investors can then use financial markets to sell their interest in the firm and match their own preferences: over time and states of the world.
