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Hi John,
i am trying to understand the concept of the PV calc after the initial 4 year period (first 4 years is clear). The answer states:
PV after 4 years (47.6 x 1.035) / (0.11 – 0.035) x (1.11 power -4)
Two parts i am struggling with:
a) 0.11 – 0.035 i.e. discount rate less the annual growth rate. What is the purpose of this?
b) 1.11 to the power of -4. I would have assumed we are looking for an annuity rate?I have watched the lectures but not sure if there is a reference to something similar?
thanks,
BrianIt is two separate things.
Firstly, if there is an inflating perpetuity as here, then you can use the dividend valuation formula on the formula sheet. It works for any inflating perpetuity – not just dividends.
So the equivalent of Do is 47.6; g is the growth rate (or inflation rate in this case) of 3.5%, and 11% is the discount rate.Secondly, however, the formula gives the present value (at time 0) if the first flow is in 1 years time.
Here, the first flow is in 5 years time, which is 4 years later than 1 years time.
So the PV resulting from the formula will also be 4 years later i.e. a PV at time 4 instead of at time 0.
Therefore we have to discount the result for 4 years at 11% (either multiplying by
( 1 / 1.11)^4 – which is the same as 1.11^(-4) – or (more sensibly really) by multiplying by the 4 year discount factor at 11% from the tables.Hi John, the point I want to make is, why do we use 47.6 to find terminal value which is after deducting additional capital investment because part of question says,” the company will require an additional investment in assets of 30c per $1 increase in sales revenue for the next four years”.so, that means after four years that investment is not required, therefore, free cash flow for terminal value calculation should be: 78-19.5=58.5 not 47.6.
Pls clarify. ThanksI understand your point, but the question specifically says that the growth rate in the free cash flows will be 3.5% after the four year period, and the free cash flow in the 4th year is 47.6, whatever the reason for it.
Having said that, you do make a valid point and using 58.5 would without doubt get you the marks (provided it was clear in your workings where the 58.5 came from).
I can see why u always say in p4 you are unlikely to arrive at the exact answer.
Thanks
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