Lecture 10 Flashcards
from nominal to real cashflows
CF_real = CF_nom / (1+p)^t
what is deflation? (in corporate finance)
deflation is a discounting based on the inflation rate rather than the cost of capital
in other words, we are defining the real value of a nominal flow with respect to a “deflated” time
the three macro components of cost of capital k
originating from the economic system
1. real risk free rate
2. inflation rate
originating from the firm/project
3. risk premium
what is the “condition of homogeneity”?
discounting nominal (real) cash flows with nominal (real) rates
!!! we can use real CFs and real rates if we ASSUME the company’s cashflows are NEUTRAL with respect to the INFLATION of the ECONOMIC system
!!! if we decide to use real flows produced by the company AND need to INCLUDE the RISK PREMIUM we must DEFLATE it
risk premium_real = risk premiun_non / (1+p)
!!! nominal risk premium is the one found in the CAPM
NOM CFs exercise
slide 14
neutral vs competitive inflation
If the company’s cash flows are expected to grow at a rate in line with inflation, then the inflation of flows is defined as “neutral”, meaning it neither adds nor subtracts value
if the expected growth of operating cashflows is =/ , the inflation is “non-neutral”
!!!!!!! in a non-neutral scenario we CANNOT discount REAL flows with REAL rates !!!!!!!
(since the inflation rate contained in the risk-free interest rate is not equal to the growth rate of operating free cash flows)
extra: formulas
why is inflation relevant in the valuation of companies?
because it appears in two different forms in the valuation formulas
- expected inflation in the economic system present in the discount rate
- “characteristic” inflation of the company: the GROWTH rate per UNIT OF PROFIT MARGIN (dynamics of prices-costs and prices-revenues)
every year the company’s flows GROW by SPECIFIC INFLATION and are DISCOUNTED based on SYSTEM INFLATION
define “company” inflation
variation in the company’s UNIT PROFIT MARGIN
what are examples of favorable / unfavorable inflation?
- unfavorable inflation: p* < p
EV will be less than in “neutral” inflation conditions. The firm is unable to “keep” inflation. - favourable inflation: p* > p
EV will be greater than in neutral inflation conditions
summary scheme of the effects of different combinations in the use of discount rates and flows
- REAL CF REAL RATES: ONLY CORRECT IN NEUTRAL INFLATION
! uses UNLIMITED capitalization of the flow at time 0 - REAL CF, NOMINAL RATES: WRONG UNDERESTIMATION
- NOM CF NOM RATE: ALWAYS CORRECT (uses gordon’s perpetual growth formula)
- NOM CF REAL RATE: WRONG OVERESTIMATION
in the gordon growth method, why is the growth rate associated with FUTURE (otherwise we underestimate values) cashflows both on numerator and denominator?
because the inflation of the economic system is already included in the cost of capital
3 possibilities when estimating TV
(useful when you have a formulated business plan in the 2 stage model)
TV =
inflation NEUTRALITY
1. [real cash flows / real rate] / discounted back to time 0 at NOMINAL rate
! no growth
- [growing (p) cashflows / (nominal rate - p) / discounted back to time 0 at NOMINAL rate
!!! p*=p
NON_NEUTRAL inflation
3. [growing (p) cashflows / (nominal rate - p) / discounted back to time 0 at NOMINAL rate
p = economic system
p* = company’s inflation
practical exercise
slide 26
real vs nominal cost of capital
K_real = i_rf + RP/(1+p)
K_nom = i_rf + RP
what does it mean to “maximize the EV”?
- max shareholder’s wealth
- minimize risk for debtholders
eventually, also max manager’s remuneration
in the presence of perfectly efficient markets, there is little room for opportunistic behaviours as favoring one of the actors will detriment another
