CASH FLOW VALUATION METHODS

3 METHODS CAPITAL CASH EQUITY CASH FREE CASH

FLOWS FLOWS FLOWS
Whole Firm Equity Value Whole Firm
Measures Cash Measures Cash Like Capital Cash
Flow available to Flow Available to Flow, Measures
both equity and Stockholders After Value of Whole
debt holders Payments to Debt Firm - Cash Flows
Holders are Do Not Include
Deducted from Tax Benefits of
Operating Cash Debt Since That is
Flows in Discount Rate

REPRESENTS REPRESENTS REPRESENTS

Includes Benefits Equity Cash Cash Flows
of tax deductible Flows Equal Available to Firm
interest payments Capital Cash if Interest Was Not
Flows minus Debt a Tax-Deductible
Cash Flows Expense

DISCOUNT DISCOUNT DISCOUNT

RATE RATE RATE
Discount Rate is Equity Cash Includes Benefit
Pre-Tax Rate That Flows are Riskier of Tax Deductible
Corresponds to Than Cash Flows Interest in
Riskiness of Firm With Debt, so Discount Rate - so
Discount Rate is 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

From Vitamin A(ccounting) to C(ash): Reverse Engineering of Cashflows

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

INPUTS NOTE
Sales ($) $5,000 COMPUTER MUST BE SET TO SOLVE
Unlevered
1.00
Beta BY ITERATION (OPTIONS MENU - CALCULATIONS)

10.00%
Riskfree Rate

8.00%
Risk Premium
Debt Ratio
40.00%
(Debt %)
Depreciation
$500
($)
Change in
Working $0
Capital
Capital
Expenditures $500
($)
EBIT Margin
40.00%
(%)
Tax Rate 40.00%
 OUTPUTS
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 ($500) ($500) ($500)
Expenditures
Change in
Working $0 $0 $0
Capital

OPERATING $2,000 $2,000 $2,000

CASH FLOW
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 Equity
Expected Asset 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