What is Cost of Equity? – Meaning, Concept and Formula
Theoretical Concept The cost of equity concept is very important when it comes to valuing shares on the stock market. Equity, like all other investment classes expects a compensation to be paid to its investors. The problem however is that unlike debt and other classes the cost of equity is never really straightforward. You can…
Cross Border Credit Reporting
The geographical boundaries drawn by nation states are blurring in the 21st century. In many parts of the world, free movement of goods, services, and even personnel have become a norm. However, strangely, the concept of credit and loans is still dependent upon national boundaries. The H1B visa system of America is a testimony to…
How Should Companies Communicate With Wall Street?
Wall Street is very sensitive to communication. Every quarter, executives from top companies communicate their results to the street. Based on the content of this communication, the market reacts. Sometimes the market turns volatile. However, at other times the market remains stable. Apart from the content being communicated, the manner in which it is also…
Cash flows vary from project to project. In some cases cash flows will occur evenly over time. There might be payments of similar amounts that will be spread out over a time period at regular intervals.
On the other hand, there might be payments which are irregular and have no pattern whatsoever. The challenge in corporate finance is to value these different streams of cash flows. Here is how this is done:
The present value of a stream of cash flows can be expressed as a lump sum amount. This can be done only after all the expected future receipts are converted to their present day values. The sum of these values is then equal to the value of the expected stream of cash flows. This is exactly how the value of a future stream of payments is derived.
The calculation of the present value of the future stream of money depends upon the nature of the cash flows. If the cash flows are spread out in an even pattern, shortcuts like annuities and perpetuities can be used and the value of large streams can also be calculated very easily. However, if the cash flows are uneven, individual payments have to be discounted to their present value and then all those payments need to be added up.
Now, there are many investments that go on for a period of 10 years, 15 years and so on. The inflation forecast does not remain the same over such an extended period of time. In fact historically, the inflation will change every time there is a change in the business cycle. Hence, for investments over a long period of time, multiple inflation forecasts may be required where different rates are used in different years.
Moreover, in projects where cash flow goes on for multiple years, the uncertainty also increases with increased time. It is a fundamental rule in corporate finance that the farther the expected payments are, the more uncertain they are. This is because over an extended period there might be political, economic or social changes that might affect the cash flows. Hence different rates may be used to discount the cash flows in different years to get a more accurate picture.
Analysts almost always use multiple discount rates to represent the different uncertainties that cash flows in different years have inherent in them. Moreover, the value of the future cash flows is highly sensitive to discount rates. Hence, small changes in the discount rate can bring about big changes in valuation. This, coupled with the fact that discount rates are very difficult to predict in advance makes investing an art rather than a science.
Article Written by
Himanshu Juneja, the founder of Management Study Guide (MSG), is a commerce graduate from Delhi University and an MBA holder from the esteemed Institute of Management Technology (IMT). He has always been someone deeply rooted in academic excellence and driven by a relentless desire to create value. Recently, he was honored with the “Most Aspiring Entrepreneur and Management Coach of 2025 (Blindwink Awards 2025)” award, a testament to his hard work, vision, and the value MSG continues to deliver to the global community.
Article Written by
Himanshu Juneja, the founder of Management Study Guide (MSG), is a commerce graduate from Delhi University and an MBA holder from the esteemed Institute of Management Technology (IMT). He has always been someone deeply rooted in academic excellence and driven by a relentless desire to create value. Recently, he was honored with the “Most Aspiring Entrepreneur and Management Coach of 2025 (Blindwink Awards 2025)” award, a testament to his hard work, vision, and the value MSG continues to deliver to the global community.
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