cash flow(s) it is expected to provide over the ownership period. - an asset does not have to provide an annual cash flow Personal Finance Example 6.4 Celia Sargent wishes to eliminate the value of three assets she is considering investing in the following: Stock in Michaels Enterprises Expect to receive cash dividends of $300 per year indefinitely. Oil Well Expect to receive cash flow of $2,000 at the end of year 1, and $4,000 at the end of year 2, and 10,000 at the end of year 4, when the well is to be sold. Original Painting Expect to be able to sell the painting in 5 years for 85,000. Timing - in addition to making cash flow estimates, we must know the timing of the cash flow. - the combination of the cash flow and its timing fully defines the return expected from the asset. Risk and Required Return - the level of risk associated with a given cash flow can significantly affect its value. - the greater the risk of (or the less certain) a cash flow, the lower its value. -greater risk can be incorporated into a valuation analysis by using a higher required return or discount rate. - the higher the risk, the greater the required return, and the lower the risk, the less the required return. Personal Finance Example 6.5 Celia Sargent’s task of placing a value on the original painting and consider two scenarios. Scenario 1: Certainty A major art gallery has contracted to buy the painting for $85,000 at the end of 5 years. Because this contract is considered a certain risk-free rate of 3% as the required return when calculating the value of the painting. Scenario 2: High Risk The values of original paintings by his artist have fluctuated widely over the past 10 years. Although Celia expects to be able to sell the painting for $85,000, she realizes that its sale price in 5 years could range between $30,000 and $140,000. Because of the high uncertainty surrounding the painting’s value, Celia believes that a %15 required return is appropriate. Personal Finance Example 6.6 Celia Sargent uses the Equation 6.4 to calculate the value of each asset. She values Michaels Enterprises stock using Equation 5.7, which says that the present value of a perpetuity equals the annual payment divided by the required return. In the case of Michaels stock, the annual cash flow is $300, and Celia decides that a 12% discount rate is appropriate for this investment. Therefore, her estimate of the value of Michaels Enterprises stock is $300 ÷ 0.12 = $2.500 (con.) Next, Celia values the oil well investment, which she believes is the most risky of the three investments. Using a 20% required return, Celia estimates the oil well’s value to be $2,000 $4,000 $10,000 + 2 + = $9,266.98 (1+0.20) (1+0.20) (1+0.20)⁴ Finally, Celia estimates the value of the painting by discounting the expected $85,000 lump sum payment in 5 years at 15%: $85,000 ÷ (1+0.15)⁵ = $42,260.02 4-5. Give 2 factors that will affect the equilibrium interest rate?