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Some Cash Flow Definitions

FCF (Free Cash Flows) - The cash that is actually available to distribute to investors after the
company has made all investments in working capital and fixed assets necessary to sustain ongoing
business operations. You would see this as dividends in a cash flow statement.
DCF (Discounted Cash Flows) - A way of measuring the intrinsic value of a company, (or asset or
project proposal), It's purpose is to figure out the company value now based upon projections of all the
cash it could potentially make available to investors in the future. The purpose of "discounting" is to take
into consideration the time value of money.

Risk and Financial Leverage (aka - Debt)

The expected return of a stock consists of it's dividend yield, (dividends paid to the stockholder
expressed as a % of the share price - ex: Apple has a dividend yield of 1.8%), and it's price
appreciation, (EX: I bought it for $10/share and I expect it to appreciate to $11/share - 10%) is
related to risk.
In the above definition/example, the expected return of this stock would be 1.8% + 10% = 11.8%
Risk averse investors must be compensated with higher returns in proportion to the higher risk
they bear. In other words, the higher the risk, the higher the expected return. One source of risk
for an investor is in the capital structure of the company - the debt portion. Investors must have a
means by which to measure this risk associated with financial leverage (debt) and it's impact on
the cost of equity capital, (in other words - what's the increase in debt going to cost the
With an increase in debt to the firm's capital structure comes an increase in the risk borne by it's
shareholders. The risk of financial distress increases with an increase in debt. A secondary
source, (or ripple effect), of risk is the effect this financial leverage has on the volatility of the
stock price/shareholder's returns. Additionally, if the firm has higher fixed expenses, then the
resulting volatility of the increase in debt will be even more evident in their operating cash flows.
In order for investors to bear the risk associated with increased financial leverage of the firm,
they must be compensated - this is the risk premium. Therefore, we can think of the the expected
return on the company's stock to look like this:
Expected Return = risk free rate + risk premium
*Note: On your Forecasting Models Worksheet - this is what Model #3 is trying to
communicate. The first part of the equation: rf is the "risk free rate" - the rate associated with
Treasury Bond yield. What this is being added to, the second part of the equation that includes
beta is the "risk premium" - your worksheet gives it as the market risk premium = 6%.

Discounted Cash Flow Valuation Video Part 1

Discounted Cash Flow Valuation Video Part 2

Part 2 is applied to a real firm.

Hi Class,

I hope you find this attachment helpful. I break down each of the formulas and valuation
definitions on your worksheet that we will be completing this Tuesday. Remember, this
worksheet is "conceptual" in nature, so the questions are looking to see your understanding of the
formulas. No calculations are being done for the worksheet. At the bottom of the attachment,
I've included some links for some basic videos on to exemplify understanding.

Module 6 Terms/Definitions/Formulas for completing the Forecasting

Worksheet and Milestone 2
Weighted Average Cost of Capital, (WAAC): (Related to Question 1 on your
Forecasting Worksheet); A Company needs to invest in assets in order to generate
revenue. In order to do this, the firm will raise equity capital through stock issuance
and/or incur debt through Bond Issuance, bank loans, and other financing
arrangements. The WAAC is the relative portion of debt and equity used by the firm
to invest in assets to the firms overall capital structure. This is the minimum rate
of return the firm must receive for its investments. An increase in any input here,
such as increase in debt or increase in the cost of debt, will increase this rate, as
well as the firms beta, and will reduce the intrinsic value of the firm.
For Example: Firm A has Debt, (this can be from bond issuance or LT debt such as
bank loans), as 40% of their capital structure and 60% Equity Ownership, (capital
provided by stock issuance). Also assume Firm As cost of debt is 6% and cost of
equity ownership, (rate of return to stockholders), of 5%.
The proportion, (or weighted average), of debt is then Debt .40 & Equity .60. We
then multiply the weighted average by the cost and add them together.
Debt = .40 x 6% + Equity .60 x 5% = 2.4% + 3% = 5.4%.
Now assume an increase in the cost of debt to 8%. This would cause an increase in
the WAAC from 5.4% to 6.2%.
If we assume an increase of the cost of debt to 8% and an increase in the amount of
debt, (increase in proportion to the overall capital structure), from 40% to 50%.
Debt weight = .50 and Equity weight = .50
This would increase the WAAC to 6.5%.
Capital Asset Pricing Model, (CAPM): (Related to Question 3 on your
Forecasting Worksheet);
An idealized representation of how capital markets price securities, (aka: stock
prices), and therefore calculate expected returns. The CAPM relates systemic risk,
(risk related to the firm), with expected return. The article also refers to this as the
Industry Cost of Equity. Because CAPM represents the risk/return tradeoff in the
market, it can be used to determine the impact of increased financial leverage on
the stock price of the firm. An impact on the stock price of the firm has an impact

on existing stock holders, (equity owners).

bearing the increased risk.

They will expect higher returns for

Referring to this formula in Question 3 on your worksheet, if we break it down, we

see that the expected return is equivalent to the risk free rate added to the market
premium as it relates to the firms beta. Therefore, as we see above in the WAAC
description, that an increase in an input here results in an increase in the WAAC
rate, which therefore increases the risk of the firm increasing the firms beta. When
the firms beta increases, we relate it to the market premium required by investors
for bearing risk beyond the risk free rate in the CAPM, and we can measure the
increase in systemic risk, that is, that risk related directly to the firm within the
industry in which it operates.

Risk Free Rate: (Intermediate rate of return on Treasury Bonds historical yield on
treasury bills) / Rate of return on Treasury Bills
Market Risk Premium: The premium required by investors for accepting risk
above and beyond the risk free rate.
Abnormal Earnings Model: (See question 2 on your Forecasting Worksheet);
Also known as the Residual Earnings Model. To understand this model, lets first
understand the difference between the Book Value of the firm and the Market
Value of the firm. The book value of the firm is an accounting value. Broadly
stated, it is calculated from the firms balance sheet as follows: Assets Liabilities =
Equity, (Book Value). What this is saying is the Equity section of the balance sheet
is effectively the book value of the firm.
The market value of the firm is the valuation of the firms stock price by the market.
Effectively the stock price.
If the book value of the firm is lower than the market value of the firm, then the firm
is valued higher than its stated value, which is good for investors. If the book value
of the firm is greater than the market value, then the market is valuing the firm for
less than its stated value, which is not good for investors. In other words, the
market doesnt believe or have faith that the firm can generate the cash flow and
profits required by investors.
Conceptually, every stock is worth the book value per share if an investor expects to
receive a normal rate of return. A rate of return that is unexpected will cause a
deviation in the firms stock price.
This deviation is typically attributed to
management whether they are over or under delivering profitability results based
upon their operation of the business. The Abnormal Earnings model attempts to
arrive at a real value of the stock based upon these deviations from the normal
Now lets look at the model 3(b) formula on your worksheet. This is also known as
the clean surplus relation. This formula is calculating the Book Value for the firm
at the end of the period. Book Value at the end of the year, B t, is equal to the book

value of the firm at t-1, (which is the BV at the beginning of the period), plus the
earnings in year t less the dividends paid to stock holders.
Moving to model 3(a), we can evaluate the Abnormal Earnings, (AE). AE t = Xt-rEBt-1
Abnormal Earnings at time t, (end of the period), is equal to the earnings in year t,
(earnings at the end of the period) less the expected return on the Book Value at
time t-1 (meaning book value at the beginning of the period).
The result of this formula tells us the amount of earnings we can attribute to
management performance over or under the normal expected return.
Now looking to model 3, we see that the market value of the firm at F, (the forecast
period), is equal to the book value of the the firm at time F plus the sum of AE t
divided by (1+rE)t, (Abnormal Earnings at time t divided by 1 + the expected return
to the power of time t.)