Introduction to Corporate Finance

Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate Edition

III. Valuation of Future

Cash Flows

6. Discounted Cash Flow
   Valuation

© The McGraw−Hill^205

Companies, 2002

CHAPTER 6 Discounted Cash Flow Valuation 175

of $1 every quarter. What dividend will Fellini have to offer if the preferred stock is going to

sell?

The issue that is already out has a present value of $40 and a cash flow of $1 every quar-

ter forever. Because this is a perpetuity:

Present value $40 $1 (1/r)

r2.5%

To be competitive, the new Fellini issue will also have to offer 2.5 percent per quarter;so, if

the present value is to be $100, the dividend must be such that:

Present value $100 C(1/.025)

C$2.50 (per quarter)

As we discussedin our previous chapter, many web sites have financial

calculators. One of these sites is MoneyChimp, which is located at

http://www.datachimp.com. Suppose you are lucky enough to have $2,000,000.

You think that you will be able to earn an 8 percent return. How much can you

withdraw each year for the next 25 years? Here is what MoneyChimp says:

According to the MoneyChimp calculator, the answer is $173,479.22. How important

is it to understand what you are doing? Calculate this one for yourself, and you

should get $187,357.56. Which one is right? You are, of course! What’s going on is

that MoneyChimp assumes (but does tell you) that the annuity is in the form of an an-

nuity due, not an ordinary annuity. Recall that, with an annuity due, the payments oc-

cur at the beginning of the period rather than the end of the period. The moral of

this story is clear: caveat calculator.

Work the Web