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Terminal value, accounting numbers, and inflation

  • In a 2008 article published in this journal, Michael Bradley and Gregg Jarrell argue that the well-known Gordon-Shapiro (henceforth “GS”) model for calculating terminal values does not properly account for the effects of inflation. Bradley and Jarrell suggest modifying the growth factor in the standard GS model by adding an additional term to the nominal growth rate that reflects the positive effect of inflation on the value of existing assets._x000D_ In this article, the authors support the original Gordon-Shapiro method for calculating terminal values by showing what they believe to be an oversight of the Bradley-Jarrell critique. According to the authors, the disagreement stems from the use of fundamentally different assumptions about the effect of inflation on the capital iestment required to sustain a business. Although Bradley-Jarrell agree with the authors that intrinsic value is the discounted value of future free cash flows, their assumptions about capital iestment effectively lead them to conclusions similar to those practitioners who attempt to value companies on the basis of discounted future accounting earnings. Despite much common practice, the GS model was meant to be applied to free cash flows, not accounting earnings. And for companies with substantial capital iestment, the differences between accounting earnings that iolve accruals and free cash flows can be very large.

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Document Type:Article
Author:Bernhard SchwetzlerORCiD
Chairs and Professorships:Chair of Financial Management
Year of Completion:2011
In: Journal of Applied Corporate Finance, 23 (2011) 2, 104-112