Financial Valuation Tool

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we usually begin by describing the valuation process of any asset or firm as comprised of a detailed prediction of expected cash flows and an estimation of the price for which these cash flows can be sold. We then proceed to describe the determinants of the price for which various cash flows can be sold—the determinants of the appropriate discount rate.

Chapter structure

In the chapter we deal sequentially with each of the characteristics of cash flows that determine the price for which the cash flows can be sold: timing, risk, purchasing power, and liquidity. Timing We spend a short amount of time reviewing the discounting of certainty cash flows at the maturity-dependent risk-free rate. Since most students are probably familiar with the technical aspects of this issue, we dedicate most of the class discussion to the economic interpretation of discounting as a way to calculate how much a certain cash flow of a given timing can be sold for in the market. We also spend considerable time discussing the Gordon formula. (Later in the book we use the formula to estimate terminal values of projected financial performance, to estimate discount rates, and to estimate appropriate multiples.) Risk We emphasize the CAPM/APT intuition of risk measurement: Risk should be measured relative to the risk to which investors are already exposed. We use the CAPM framework to proxy for investors’ existing risk by the variation in the return on the market portfolio. The discussion of practical ways to estimate risk-adjusted discount rates is deferred to Chapter 9.

Benninga/Sarig, Instructor’s Manual, Chapter 1

Page 1

Inflation and the purchasing power of money The issue of changing purchasing power of money (i.e., inflation) is often confusing to students who tend to dismiss it as irrelevant. We emphasize that in valuations, which are based on projections of long or even infinite cash flows, the effect of even a low annual rate of inflation is material. We often use “The...