Final answer:
The scenario where a firm has a higher break up value ($20 million) than its present value of cash flow ($15 million) is an example of an asset play according to Peter Lynch. An asset play occurs when a company's assets are undervalued in the market, potentially offering an investment opportunity with capital gains through the sale of individual assets.
Step-by-step explanation:
You estimate that the present value of a firm's cash flow is valued at $15 million. The break up value of the firm if you were to sell the major assets and divisions separately would give $20 million. This is an example of what Peter Lynch would call an asset play. Peter Lynch categorized investments into six different categories: slow growers, stalwarts, fast growers, cyclicals, turnarounds, and asset plays. An asset play is when a company's market value is less than its break up value, essentially suggesting that the company's assets are undervalued on the market. In this case, the difference in present value cash flow versus the breakup value indicates that the firm is worth more when its assets are considered separately, a characteristic of an asset play.
When assessing the value of an investment, it's crucial to consider both present discounted value and the potential for capital gains or dividends. Present discounted value calculations involve determining what a future amount is worth today, given a specific interest rate. This involves discounting future sums, such as the $20 million in one year and $25 million in two years, back to their present value at the given rate. Then, to calculate a per-share value, you divide this total profit by the number of shares. For instance, if the present discounted value (PDV) of total profits is $51.3 million for a company with 200 shares, you get a price per share of about $256,500.