Cash Flows (Returns)

-the value of any asset depends on the

cash flow(s) it is expected to provide over the
ownership period.
- an asset does not have to provide an
annual cash flow
Personal Finance Example 6.4
Celia Sargent wishes to eliminate the value of three
assets she is considering investing in the following:
Stock in Michaels Enterprises Expect to
receive cash dividends of $300 per year indefinitely.
Oil Well Expect to receive cash flow of $2,000
at the end of year 1, and $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.
Timing
- in addition to making cash flow
estimates, we must know the timing of the cash
flow.
- the combination of the cash flow and its
timing fully defines the return expected from
the asset.
Risk and Required Return
- the level of risk associated with a given
cash flow can significantly affect its value.
- 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.
- the higher the risk, the greater the
required return, and the lower the risk, the less
the required return.
Personal Finance Example 6.5
Celia Sargent’s task of placing a value on the 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 contract is considered a certain risk-free
rate of 3% as the required return when calculating the value
of the painting.
Scenario 2: High Risk The values of original paintings
by his artist have fluctuated widely over the past 10 years.
Although Celia expects to be able to sell the painting for
$85,000, she realizes that its sale price in 5 years could
range between $30,000 and $140,000. Because of the high
uncertainty surrounding the painting’s value, Celia believes
that a %15 required return is appropriate.
 Personal Finance Example 6.6
Celia Sargent uses the Equation 6.4 to calculate
the value of each asset. She values Michaels
Enterprises stock using Equation 5.7, which says
that the present value of a perpetuity equals
the annual payment divided by the required
return. In the case of Michaels stock, the annual
cash flow is $300, and Celia decides that a 12%
discount rate is appropriate for this investment.
Therefore, her estimate of the value of Michaels
Enterprises stock is
$300 ÷ 0.12 = $2.500
(con.)
Next, Celia values the oil well investment, which
she believes is the most risky of the three
investments. Using a 20% required return, Celia
estimates the oil well’s value to be
$2,000 $4,000 $10,000
+ 2 + = $9,266.98
(1+0.20) (1+0.20) (1+0.20)⁴
Finally, Celia estimates the value of the
painting by discounting the expected $85,000
lump sum payment in 5 years at 15%:
$85,000 ÷ (1+0.15)⁵ = $42,260.02
4-5. Give 2 factors that will affect the
equilibrium interest rate?