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DiscountedCashFlowsandValuation

DiscountedCashFlowsand
Valuation

LearningObjectives
1 Explainwhycashflows
occurringatdifferenttimes
mustbeadjustedtoreflect
theirvalueasofacommon
datebeforetheycanbe
compared,andcomputethe
presentvalueandfuture
valueformultiplecashflows.
2 Describehowtocalculate
thepresentvalueandthe
futurevalueofanordinary
annuityandhowanordinary
annuitydiffersfroman
annuitydue.
3 Explainwhataperpetuityis
andwhereweseethemin
business,andcalculatethe
valueofaperpetuity.
4 Discussgrowingannuities
andperpetuities,aswellas
theirapplicationinbusiness,
andcalculatetheirvalues.
5 Discusswhytheeffective
annualinterestrate(EAR)is
theappropriatewayto
annualizeinterestrates,and
calculatetheEAR.

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DiscountedCashFlowsandValuation

nJanuary18,2010,theBoardofDirectorsatCadburyPLC,thesecondlargestconfectionarycompany

intheworld,recommendedtoitsstockholdersthattheyacceptatakeoverofferfromKraftFoods.The
announcementendedatakeovercontestthathadbegunfourmonthsearlierandthathadtakenonmanyofthe
characteristicsofthehostiletakeovercontestsfromthe1980s.ByApril2010,CadburyPLCwasnolongeran
independentcompany.
Cadbury,foundedin1824inBirmingham,England,waswidelyviewedbytheBritishpublicasanational
treasure.TheofferfromKraft,anAmericancompany,metwithwidespreadoppositionfromtheBritish
public,laborunions,andpoliticians,aswellastheCadburyboard.ItalsofueledspeculationthatHershey
Foods,Nestl,orbothwouldmakeacompetingfriendlyoffer.Infact,Hersheyhiredaninvestmentbanker
andheldprivatetalkswithCadburyaboutapossibledeal.
Intheend,however,KraftprevailedbyofferingapricethatneitherHersheynorNestlwaswillingtomatch.
Overthefourmonthperiod,Kraftraiseditsofferfrom$16.2billionto$18.9billion.Thefinaloffer
representeda49.6percentpremiumoverthepriceatwhichCadbury'sstockhadbeentradingbeforethe
contestbeganandattractedsomuchsupportfromkeystockholdersthattheCadburyboardhadnochoicebut
tobackdownfromitsoppositiontothedeal.ThecombinationofKraftandCadburybroughttogetherwell
knownKraftbrandssuchasOreocookies,Tobleronechocolates,andRitzcrackerswithCadburybrandssuch
asTridentgumandDairyMilkchocolates.
Intheexcitementofsuchatakeovercontest,itisimportantnottolosesightofthecentralquestion:Whatis
thefirmreallyworth?Acompanyinvestsinanassetabusinessoracapitalprojectbecauseitexpectsthe
assettobeworthmorethanitcosts.That'showvalueiscreated.Thevalueofabusinessisthesumofits
discountedfuturecashflows.Thus,thetaskforKraftwastoestimatethevalueofthecashflowsthatCadbury
wouldgenerateunderitsownership.Whetherthe$18.9billionpricetagisjustifiedremainstobeseen.This
chapter,whichdiscussesthediscountingoffuturecashflows,providestoolsthathelpanswerthequestionof
whatCadburyisworthtoKraft.

CHAPTERPREVIEW
InChapter5weintroducedtheconceptofthetimevalueofmoney:Dollarstodayaremorevaluable
thandollarstobereceivedinthefuture.Startingwiththatconcept,wedevelopedthebasicsofsimple
interest,compoundinterest,andfuturevaluecalculations.Wethenwentontodiscusspresentvalue
anddiscountedcashflowanalysis.Thiswasalldoneinthecontextofasinglecashflow.
Inthischapter,weconsiderthevalueofmultiplecashflows.Mostbusinessdecisions,afterall,involve
cashflowsovertime.Forexample,ifHatterasHammocks,aNorthCarolinabasedfirmthat
manufactureshammocks,swings,androckers,wantstoconsiderbuildinganewfactory,thedecision
willrequireananalysisoftheproject'sexpectedcashflowsoveranumberofperiods.Initially,there
willbelargecashoutlaystobuildandgetthenewfactoryoperational.Thereafter,theprojectshould
producecashinflowsformanyyears.Becausethecashflowsoccurovertime,theanalysismust
considerthetimevalueofmoney,discountingeachofthecashflowsbyusingthepresentvalue
formulawediscussedinChapter5.
Webeginthechapterbydescribingcalculationsoffutureandpresentvaluesformultiplecashflows.
Wethenexaminesomesituationsinwhichfuturecashflowsarelevelovertime:Theseinvolve
annuities,inwhichthecashflowstreamgoesonforafiniteperiod,andperpetuities,inwhichthe
streamgoesonforever.Next,weexamineannuitiesandperpetuitiesinwhichthecashflowsgrowat
aconstantrateovertime.Thesecashflowsresemblecommoncashflowpatternsencounteredin
business.Finally,wedescribetheeffectiveannualinterestrateandcompareitwiththeannual
percentagerate(APR),whichisaratethatisusedtodescribetheinterestrateinconsumerloans.

Copyright2012JohnWiley&Sons,Inc.Allrightsreserved.

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