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Hi john,
In September/december hybrid paper you need to calculate the pv of free cash flows from year 5.The free cash flow in year 4 is 2103 and has a growth rate of 3% thereafter.
The cost of capital is 9%.
Can you tell me how to calculate the Npv of the project from year 5 please?
I don’t understand the following answer:
(£2103 x 1.03) / (0.09-0.03) x (1.09^-4) = £25,575
Thank you John
The first part of the answer – (2103 x 1.03) / (0.09 – 0.03) – is using the dividend growth formula from the formula sheet. You can use this formula to get the present value of any flow that is in perpetuity and inflating. g in the formula is the growth/inflation rate, with is 3%, and Re in the formula is the discount rate which is 9%.
However, that formula gives the PV providing that the first flow is in 1 years time, and thereafter in perpetuity.
However here, the first flow is in 5 years time, which is 4 years later than 1 years time.
Therefore instead of giving a PV ‘now’ (time 0) it gives a PV 4 years later – i.e. at time 4.Therefore to get the PV ‘now’, we need to discount the answer for 4 years at 9% (which is the last part of the answer ( 1.09^-4) – although it is just as valid to multiply by the 4 year discount factor at 9% from the tables, rather than use first principles to get the discount factor)
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