Hi John, regarding example 5, it says the cash flows have been forecast at $5000 p.a, and inflating at 4% p.a., does it means in year 1, we will get cash flow 5000*(1.04) straight away? Would it be possible to have $5000 in year 1 and then inflating at 4% (if it is the case, how would the wording be)? Thanks heaps in advance!

Yes – in example 5 the cash flow will be 5.000 x 1.04 in 1 years time.

And yes it is possible to have an actual 5,000 at time 1 and for it then to inflate at 4% per year. It would be worded as you have done (or in the same sort of way as example 6 is worded).

Yes you can, because the formula I use in this example is derived from the formula for getting the real rate (if you are good at algebra then you can arrive at it yourself).

However, it is a bit quicker to use the dividend valuation formula because it is given on the formula sheet 馃檪

Hello sir, what if the inflation rate is higher than the discount rate and is this possible in any case? As the discount rate includes the impact of inflation, is it practically possible that the inflation rate be higher than the discount rate?

In example 6, why do we use the growth model formula starting in year 4 when the first flow is in year 3 (7,000) and inflating at a rate of 5% thereafter. So this way the formula would discount the perpetuity back to year 2 i/o year 3 as you explained in your workings.

You should remember from Paper PM (was F9) that when dealing with an inflating perpetuity (which in Paper FM was usually inflating dividends) that if the inflating stream started at time 1, then in the formula we put as Do the current dividend that has just been paid (i.e. at time 0).

Here, instead of the inflating stream starting at time 1, I have taken it as starting at time 4 (and discounting the time 3 flow separately). Therefore for Do in the formula we use the time 3 flow of 7,000.

By all means use the formula for the stream starting at time 3 instead, and discount the answer for 2 years, but then you need to use D0(1+g) as being 7,000 (and not 7,000 x (1+g)). You will get the same answer:

(7,000 / (0.20 – 0.05) ) x ((1/1.20)^2) = 32,407.

This is the same as the PV of 7,000 in 3 years time, plus the PV of the inflating stream from time 4 onwards as in the lecture. 4,053 + 28,371 = 32,423

(The difference is simply due to the rounding of the discount factors and is, as always, irrelevant in the exam)

Dear Sir, excellent lecture. although obvious, and too time consuming could we find the yr1 to 3 perpetuity using the growth model and deduct it from the 1 to infinity?

The dividend valuation formula give the PV for any inflating perpetuity. If the first flow is in 1 years time then it gives a PV at time 0. If the first flow is in 4 years time then it gives a PV at time 3.

jocelynjm says

Hi John, regarding example 5, it says the cash flows have been forecast at $5000 p.a, and inflating at 4% p.a., does it means in year 1, we will get cash flow 5000*(1.04) straight away?

Would it be possible to have $5000 in year 1 and then inflating at 4% (if it is the case, how would the wording be)?

Thanks heaps in advance!

John Moffat says

Yes – in example 5 the cash flow will be 5.000 x 1.04 in 1 years time.

And yes it is possible to have an actual 5,000 at time 1 and for it then to inflate at 4% per year. It would be worded as you have done (or in the same sort of way as example 6 is worded).

jocelynjm says

Thank you 馃檪

John Moffat says

You are welcome 馃檪

ashrf16 says

sir,

can i use the method you used in f9 for this kind of questions? actual interest = real interest * inflation rate.

ashrf16 says

and discount with real interest rate?

John Moffat says

Yes you can, because the formula I use in this example is derived from the formula for getting the real rate (if you are good at algebra then you can arrive at it yourself).

However, it is a bit quicker to use the dividend valuation formula because it is given on the formula sheet 馃檪

Mahrukh says

Hello sir, what if the inflation rate is higher than the discount rate and is this possible in any case? As the discount rate includes the impact of inflation, is it practically possible that the inflation rate be higher than the discount rate?

John Moffat says

Theoretically it would be possible, but in practice and (more importantly, in the exam) it will not be higher.

Mahrukh says

Thankyou 馃檪

John Moffat says

You are welcome 馃檪

peterkocsis says

Dear Sir,

In example 6, why do we use the growth model formula starting in year 4 when the first flow is in year 3 (7,000) and inflating at a rate of 5% thereafter. So this way the formula would discount the perpetuity back to year 2 i/o year 3 as you explained in your workings.

Thank you for your reply in advance!

Regards,

Peter

John Moffat says

You should remember from Paper PM (was F9) that when dealing with an inflating perpetuity (which in Paper FM was usually inflating dividends) that if the inflating stream started at time 1, then in the formula we put as Do the current dividend that has just been paid (i.e. at time 0).

Here, instead of the inflating stream starting at time 1, I have taken it as starting at time 4 (and discounting the time 3 flow separately). Therefore for Do in the formula we use the time 3 flow of 7,000.

By all means use the formula for the stream starting at time 3 instead, and discount the answer for 2 years, but then you need to use D0(1+g) as being 7,000 (and not 7,000 x (1+g)). You will get the same answer:

(7,000 / (0.20 – 0.05) ) x ((1/1.20)^2) = 32,407.

This is the same as the PV of 7,000 in 3 years time, plus the PV of the inflating stream from time 4 onwards as in the lecture. 4,053 + 28,371 = 32,423

(The difference is simply due to the rounding of the discount factors and is, as always, irrelevant in the exam)

loukasierides says

Dear Sir,

excellent lecture. although obvious, and too time consuming could we find the yr1 to 3 perpetuity using the growth model and deduct it from the 1 to infinity?

John Moffat says

loukasierides: Yes (but as you say it would be time consuming 馃檪 )

loukasierides says

thank you very much

lucie13 says

Excellent lecture!

John Moffat says

Thank you for your comment 馃檪

mitshu says

Hi, sir. As for example 6, why PV of $49,000 is not discounted using year 4 rate 0.482? (20%@4 year)

Thank you.

shasha82 says

Hi Sir. For example 6, I used PV of year 3 ($4053) to infinity, i get the same answer of $28371. Is this method correct?

John Moffat says

Yes – that is fine 馃檪

shasha82 says

Thank you Sir!

John Moffat says

You are welcome 馃檪

melissahurley says

Sir why do we take the pv of 1 to infinity as the pv of 4 to infinity?

John Moffat says

The dividend valuation formula give the PV for any inflating perpetuity. If the first flow is in 1 years time then it gives a PV at time 0. If the first flow is in 4 years time then it gives a PV at time 3.