Start-Up Valuation: Advanced Concepts
In the previous articles, we have already studied the basics of start-up valuation. We are also aware of the basic concepts such as pre-money valuation and post-money valuation which commonly affect the funding received by startups. However, the cases mentioned until now were very simple. These cases are only presented for the student to gain […]
Estimating Project Cash Flows: Part 1
Prima facie, capital budgeting may seem like a very simple task. After all, it has just 3 steps. The first is to find the cash flows, the second is to find the appropriate discount rate that represents the time value and riskiness of those cash flows and the third step is to use both these […]
Valuing Preference Shares Using Dividend Discount Model
The dividend discount model is also used to measure the value of preference equity in addition to forecasting the value of ordinary equity. There are certain assumptions and clarifications that need to be made regarding the use of dividend discount model for valuing preference equity. The purpose of this article is to provide this information […]
Retail Inventory Method (RIM)
Inventory is a very important part of the retail business. This is because the stock which retail stores hold on their books is their most important asset. The quality of this asset allows them to generate higher profits as compared to their peers. Hence, the valuation of inventory which is held by the retailer is […]
Distribution of Risks in an Infrastructure Project
Infrastructure projects tend to have a lot of financial risks. In many cases, the risks are poorly managed. In fact, incorrect risk management is one of the main reasons behind the delay, which can cause cost overruns in the long term. It is difficult to reduce the total risk that any infrastructure project faces. However, […]
We have seen that a perpetuity represents an infinite stream of future cash flows. However, we have also seen that as time passes the value of these cash flows constantly diminishes. $100 may be able to buy us quite a few goods today, but in 50 years time $100 will not be nearly as valuable as it is today. It is for this reason that receiving infinite payments is not enough. The payments must also keep growing at a certain rate. This will ensure that they are not considerable behind inflation. This is the idea behind a growing perpetuity. The same has been explained in detail in this article:
As already stated, a growing perpetuity involves payments that do not remain fixed. Instead these payments keep on growing at the same constant rate of growth. So, if the rate of growth of the payments is 7%, each payment will be 7% more than the payment received before it.
The present value of a growing perpetuity can be derived from a complex mathematical calculation. This is because a growing perpetuity is also an infinite series which has a finite sum. For our purposes, we can just remember the formula required for our calculation.
Present Value (Growing Perpetuity) = D / (R - G)
Where:
D = Expected cash flow in period 1
R = Expected rate of return
G = Rate of growth of perpetuity payments
However, we need to understand that for this formula to hold true, G must always be greater than R. If G is less than R or equal to R, the formula does not hold true. This is because, the stream of payments will cease to be an infinitely decreasing series of numbers that have a finite sum.
Examples:
Growing perpetuities are found in a variety of places in our daily lives. Some of them have been mentioned below:
The growing perpetuity, thus assumes that we will lose a small amount of the real value of money every year. Just like the perpetuity, a growing perpetuity can only be summed up because the series is infinitely decreasing. The growing perpetuity assumes that we will lose the real value of money at a slower rate as compared to an ordinary perpetuity.
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