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To: Murti Gajjala who wrote (29)	1/2/1997 10:05:00 AM
From: shean bond	of 82

Murti, I carried out the following calculation to compare Hagstrom's calculation of company value. I get some interesting results: eg, We know a company's earnings in 1997 and will use an expected earnings growth rate of 5% and long term bond rate of 9%. The company's value is calculated for 1998 and then discounted to 1997. (This is essentially the residual value calculation, ie the second stage, of Hagstrom's two stage dividend discount model.) Earnings in 1997 $100M Expected growth rate 5% Expected earnings in 1998 $105M Long term bond rate 9% Capitalisation rate 9% Value of company in 1998 =105/0.09 = $1167M Value of co. discounted to 1997 =1167/1.09 = $1070M Using Hagstrom's method... Earnings in 1997 $100M Expected earnings in 1998 $105M Capitalisation rate = 9%-5% = 4% Value of co. in 1998 = 105/0.04 = $2625M Value of co. disc to 1997 = 2625/1.09= $2408M Hagstrom's method results in a calculated company value of almost 2.5x the value that I calculate due to the difference in capitalisation rate. I think that the former calculation is correct. My argument is as follows: The capitalisation rate is trying to take a company's earnings and from this number calculate the equivalent capital value based on a benchmark rate of return (being the risk free rate). This risk free rate is the rate at which cash flows are discounted for discounted cash flow (DCF) calculations and should be the minimum acceptable rate of return from an investment. That is, it is the minimum IRR that is acceptable to the investor. If carrying out a DCF calculation that included a growth term of 5% and a discount rate of 9%, it would be a mathematically correct approximation to merely discount the cash flow by 4% per year. However, the minimum acceptable IRR still remains 9%, not 4%. The capitalisation rate should therefore remain at 9%. The discounting of a series of cash flows by 4% is just a mathematical convenience. It should not be used for the IRR hurdle. I'd be interested in your comments on the above. Shean

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