Financial mathematical aspects of separating the value creation process into time components

Abstract

THE AIMS OF THE PAPER

Two-stage models applied in company valuation separate the expectable future cash flows into two components: a finite and an infinite cash flow series. The present value of the total cash flow series is a sum of the two components’ present values. The absolute values and the ratio between the two components vary among different assumptions. In this study, authors prove that, in case of simple and growing annuity-based two stage models, there is a deterministic relation between the value contributions of the finite and infinite periods, which does not depend on whether cash-flows are realized at the beginning or at the end of each year. Furthermore, authors identify those interest rate-growth rate combinations under different lengths of the finite period, where the value contributions of the two stages are equal. This financial mathematical investigation aims to serve as a basis for renewing the valuation methods used in company valuation.

METHODOLOGY

After a thorough literature survey, authors use a theoretical approach and financial mathematical tools to examine the value contributions of the finite and the infinite period under two-stage valuation models with different assumptions.

MOST IMPORTANT RESULTS

The main results of this research are proving the deterministic relation between the value contributions of the two stages, and the graphical presentation of the effects of different interest rate-growth rate combinations on value.

NEW FINDINGS, EMPIRICAL IMPLICATIONS OF THE RESEARCH

This research may widen the domestic literature with new theoretical findings, given that authors did not find similar examinations among earlier published Hungarian studies. Furthermore, these theoretical findings may serve as a basis for later empirical research.