Cost of Capital: Applications and Examples, + Website, 5th Edition

CHAPTER 4

Discounting versus Capitalizing

Introduction

Capitalization Formula

Example: Valuing a Preferred Stock

Functional Relationship between Discount Rate and Capitalization Rate

Major Difference between Discounting and Capitalizing

Constant Growth or Gordon Growth Model

Criticisms of the Gordon Growth Model

Combining Discounting and Capitalizing

Two-stage Model

Three-stage Model

Three-stage Model with Gradual Change in Growth

Equivalency of Discounting and Capitalizing Models

Summary

Appendix 4A: Equivalency of Capitalizing Residual Income

INTRODUCTION

The first three chapters explained that the cost of capital is used as a discount rate to discount a stream of future economic income to a present value. This valuation process is called discounting.

In discounting, we project all expected economic income (cash flows or other measures of economic income) from the subject investment to the respective class or classes of capital over the life of the investment. Thus, the percentage return that we call the discount rate represents the total compound rate of return that an investor in that class of investment requires over the life of the investment.

There is a related process for estimating present value, which we call capitalizing. In capitalizing, instead of projecting all future economic income to the respective class(es) of capital, we focus on the economic income of just one single period, usually the normalized economic income expected in the year immediately following ...