Chapter 11 Valuation: Cash Flow

Valuation: Cash basis better than Accrual? Accrual earnings cannot be spent Debatable, legitimate accounting Earnings management

Cash Flows: Three Components Periodic Cash Flow Terminal Value Discount Rate

Periodic Flows Dividend payment irrelevant for valuation Use expected free cash flows –Unleveraged vs. Leveraged Free cash flow = Cash Flow available for a stated purpose

Unleveraged Free Cash Flows Cash Flow from Operations –ignoring interest costs (net of tax) Adjusted for Investing Activities Provides Unleveraged FCF for Creditors and Shareholders

Leveraged Free Cash Flows Cash Flow from Operations Adjust for Interest Expense (net) Adjust for Investing Activities Adjust for Borrowings Adjust for Pfd Stock and Pfd Div Leveraged FCF for Shareholders

Free Cash Flows Unleveraged Free Cash Flow –appropriate for valuation of assets –appropriate discount rate is weighted avg. cost of capital Leveraged Free Cash Flow –appropriate for valuation of equity –appropriate discount rate is cost of equity capital

Terminal Period Focus: Cash Flow Equilibrium Text:Four to Seven Years Typical: Five Years Occasional: Ten Years What occurs after forecast horizon?

Residual Value Post-Terminal Period value Value at end of Forecast Period = Periodic CF (n-1) x (1 + g) (1 + r) Last CF grows at a rate “g”

Negative or No-Growth Valuation Periodic CF (n-1) x (1 + g) (1 + r) Just modify “g” Problem? When “g” results in “r”

Discount Rate “r” Cost of Capital Cost of Debt Capital Cost of Pfd Equity Capital Cost of Common Equity Capital

Cost of Debt Debt Vs. Liabilities –focus on interest-bearing debt –ignore operating liabilities Weighted-average cost of debt –Yield to Maturity * (1-t) –Adjust for leases to current interest rate on collateralized borrowing with equivalent risk.

Cost of Preferred Equity Read the Pfd Stock contract: Depends on preference conditions Cost of Pfd Equity Capital ? Cost = dividend rate –Net of tax? Convertible PS cost = f(cost of nonconv. PS and common equity)

Cost of Equity Capital CAPM -> B (systematic risk) Beta>1.0 indicates higher than average risk CoCE = R f + B (R m - R f ) R f ? Intermediate term US debt –Historically, 6% Vs. Today? B ? Effect on Cost of Equity? R m? Defend your choice. Historically, 9- 13%