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Lecture 21

BU457 Lecture 21: The Present Value Model

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Bixia Xu

The Present Value Model The Present Value Model Under Certainty • Certainty: the future cash flows of the firm and the interest rate in the economy are publicly known with certainty o Denoted as ideal conditions • Relevant financial statement information gives information to investors about the firm’s future economic prospects • Under ideal conditions, the firm’s dividend policy will not affect its value o Called dividend irrelevancy o As long as investors can invest any dividends they receive at the same rate of return as the firm earns on cash flows not paid in dividends, the PV of investor’s overall interest in the firm is independent of the timing of dividends o This holds because there is only one interest rate in the economy o Under dividend irrelevancy, cash flows are just as relevant as dividends, because cash flows establish the firm’s dividend-paying ability o As a result, the financial statements are entirely relevant • The firm’s net income plays no role in firm valuation under ideal conditions o Future cash flows are known and hence can be discounted to provide balance sheet valuations o Net income is then perfectly predictable o In effect, under ideal conditions, the balance sheet contains all the relevant information and the income statement contains none o There is no information in the current net income that helps investors predict future economic prospects of the firm, as these are already known to investors and are capitalized into asset valuation • Reliable financial statement information faithfully represents what it is intended to represent o Under ideal conditions, since future cash flows and the interest rate are known with certainty, any attempt by management to hide assets and liabilities, or bias inputs into the present value calculations, and any errors would be immediately discovered • Under the ideal conditions of future cash flows known with certainty and the economy’s risk-free interest rate given, the present value of an asset or liability will equal its market value o Arbitrage: if market prices for identical goods and services are such that it is possible to make a profit by simply buying in one market and selling in another • If a firm has more than one asset, the market value of the firm would be sum of its value of its financial assets plus the present value of the joint future receipts from its capital assets, including its intangibles, less present value of any liabilities o At the points after time 0, the firm’s market value continues to equal the sum of its financial assets plus capital assets, net of liabilities o Dividend policy affects the amount of financial assets, as retained dividend will earn a return on reinvested assets • Summary o Under the ideal conditions of future cash flows known with certainty and a given interest rate in the economy, it is possible to prepare completely relevant and reliable financial statements o The process of arbitrage ensures that the market value of an asset equals the present value of its future cash flow o The market value of the firm is then the value of its net financial assets plus the value of its capital assets (less any ot
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