CASH FLOW VALUATION METHODS

CAPITAL CASH EQUITY CASH FREE CASH

3 METHODS FLOWS FLOWS FLOWS
Whole Firm Equity Value Whole Firm
Measures Cash Measures Cash Like Capital
Flow available to Flow Available to Cash Flow,
both equity and Stockholders Measures Value
debt holders After Payments of Whole Firm -
to Debt Holders Cash Flows Do
are Deducted Not Include Tax
from Operating Benefits of Debt
Cash Flows Since That is in
Discount Rate
REPRESENTS REPRESENTS REPRESENTS
Includes Benefits Equity Cash Cash Flows
of tax deductible Flows Equal Available to Firm
interest Capital Cash if Interest Was
payments Flows minus Not a Tax-
Debt Cash Flows Deductible
Expense
DISCOUNT DISCOUNT DISCOUNT
RATE RATE RATE
Discount Rate is Equity Cash Includes Benefit
Pre-Tax Rate Flows are Riskier of Tax Deductible
That Than Cash Flows Interest in
Corresponds to With Debt, so Discount Rate -
Riskiness of Firm Discount Rate is so After-Tax
Higher Discount Rate is
appropriate

BEGINNING Beginning Point for All 3 Measures is Earnings Before Interest & Taxes
POINT or EBIT
FOR ALL
3 MEASURES

PURPOSE Purpose of Cash Flow Measures is to Transform Accounting Recognition

OF of Receipts and Expenses Into Cash Flow Definitions
MEASURES
TO ADJUST Adjustments Include:
ACCOUNTING 1. Subtracting Capital Expenditures
FIGURES 2. Adding Depreciation
3. Subtracting Changes in Working Capital
 DISCOUNT Capital Cash Flows:
RATES FOR Use CAPM to Determine Appropriate Discount Rate - Use Asset Beta
THE Since CCF Values Whole Firm
3 METHODS
Expected Return = Riskfree Rate + [ (Asset Beta) * (Risk Premium) ]
Note: Before Tax Rates

Equity Cash Flows:

Use CAPM to Determine Appropriate Discount Rate - But Use Equity Beta
Since ECF Values Equity Cash Flows
Note: Unlevered (Equity) Beta = Levered Beta / (1 + D/E Ratio)
e.g., Equity = 60%, Levered Beta = 1.667
Unlevered (Equity) Beta = 1 /(1 + .40/.60) = 1.0

Expected Return = Riskfree Rate + [ (Equity Beta) * (Risk Premium) ]

Free Cash Flows:

Appropriate Discount Rate is WACC
Since FCF Values Whole Firm

WACC = ( Debt / Value) ( 1 - Tax Rate ) * kD + ( Equity / Value ) * kE

SUMMARY OF CASH FLOW VALUATION METHODS

Earnings Before Interest & Taxes

EBIT

Plus: Depreciation
Less: Capital Expenditures
Less: Working Capital Increase

Equals
Operating Cash Flow
\|/ \|/ \|/
Subtract Actual Subtract Actual Subtract
Taxes [(Tax Rate) Taxes [(Tax Rate) Hypothetical
* (EBIT - * (EBIT - Taxes (Tax Rate)
Interest)] Interest)] * EBIT)
\|/ \|/ \|/
\|/ Less: Interest \|/
Less: Debt
\|/ Payments \|/
Plus: Debt
\|/ Issues \|/
\|/ \|/ \|/
CAPITAL CASH EQUITY CASH FREE CASH
FLOW FLOW FLOW

Discount at
Discount At
Discount at Weighted
Expected Asset
Expected Equity Average Cost of
Return (Before
Return Capital (After
tax rates)
tax rates)
 CASH FLOW VALUATION MODEL

INPUTS NOTE

$5,000

Sales ($) COMPUTER MUST BE SET TO SOLVE

Unlevered
Beta 1.00 BY ITERATION (OPTIONS MENU - CALCULATIONS)

10.00%

Riskfree Rate

Risk Premium 8.00%

40.00%

Debt Ratio
(Debt %)
Depreciation
($) $500
Change in
Working $0
Capital
Capital
Expenditures $500
($)
EBIT Margin
(%) 40.00%
Tax Rate 40.00%
 COMPUTER GENERATED ANALYSIS
CAPITAL CASH EQUITY CASH FREE CASH
FLOW FLOW FLOW
VALUATION VALUATION VALUATION

Debt Err:522 Err:522 Err:522

Debt = Debt% * Debt = Debt% * Debt = Debt% *
Firm Value Firm Value Firm Value
Sales $5,000 $5,000 $5,000
EBIT Margin 40.00% 40.00% 40.00%
EBIT $2,000 $2,000 $2,000
Depreciation $500 $500 $500
Capital
Expenditures ($500) ($500) ($500)
Change in
Working $0 $0 $0
Capital
OPERATING
CASH FLOW $2,000 $2,000 $2,000
Taxes Err:522 Err:522 $800
Taxes = TR * Taxes = TR * Taxes = TR *
(EBIT - Interest) (EBIT - Interest) (EBIT)
Interest Err:522 Err:522 Err:522
Err:522
Debt Cash Flow
Err:522 Err:522 $1,200

Capital Cash Flow Equity Cash Flow Free Cash Flow

18.00% 23.33% 16.40%
Weighted
Expected Asset Expected Equity
Average Cost of
Return Return
Capital
Err:522 Err:522 $7,317
Capital Cash Flow Equity Cash Flow Free Cash Flow
Value Value Value
Err:522
Debt Value
Err:522
Equity Cash Flow
& Debt Value