CHAPTER 1How to Value an Asset

 

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Three Primary Components of Value

In this chapter, we discuss the three main components necessary to calculate the value of an asset: the cash flows, the uncertainty of receiving the cash flows, and the time value of money. We show these components in Figure 1.1

Chart shows value of asset divided into cash flow, uncertainty, and time value of money, where cash flow is divided into timing, duration, magnitude, and growth.

Figure 1.1 Primary Components to the Value of an Asset

Four Subcomponents of Cash Flow

The first part of the definition, “Cash flows produced by that asset, over its useful life,” includes four subcomponents: timing, duration, magnitude, and growth, as shown in Figure 1.2.

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Figure 1.2 Four Cash Flow Subcomponents

The first subcomponent, timing, addresses the question, “When will we get the cash?” Will we get the cash flow next year or in five years? While the amount of the cash flow is the same in Figures 1.3A and B, the cash flow is received sooner in A than in B. All else being equal, getting cash sooner is better than getting it later.

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Figure 1.3 Getting Cash Sooner Is Preferable

The second subcomponent, duration, addresses the question, “How long will the cash flows last?” ...

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