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Cash Flows, Terminal Value and Cost of Capital
Ignacio Vélez–Pareja
Politécnico Grancolombiano
Bogotá, Colombia
ivelez@poligran.edu.co
Antonio Burbano–Pérez
Universidad de los Andes
Bogotá, Colombia
ajb@adm.uniandes.edu.co
We wish to thank Joseph Tham from Duke University the fruitful discussions we had on this paper, in particular the
appendix on perpetuities.
Any error or mistake is our entire responsibility.
First version: December 9, 2003
This version: May 30, 2005
ii
Abstract
Practitioners and teachers very easily break some consistency rules when doing or teaching
valuation of assets. In this short and simple note we present a practical guide to call the attention
upon the most frequent broken consistency rules. They have to do firstly with the consistency in
the matching of the cash flows, this is, the free cash flow (FCF), the cash flow to debt (CFD), the
cash flow to equity (CFE) and the tax savings or tax shield (TS). Secondly, they have to do with
the proper expression for the cost of unlevered equity with finite cash flows and perpetuities.
Thirdly, they have to do with the consistency between the terminal value and growth for the FCF
and the terminal value and growth for the CFE, when there is a jump in the CFE due to the
adjustment of debt to comply with the leverage at perpetuity. And finally, the proper
determination of the cost of capital either departing from the cost of unlevered equity (Ku) or the
cost of levered equity (Ke). In the Appendixes we show some algebraic derivations and an
example.
Key Words
Cash flows, free cash flow, cash flow to equity, valuation, levered value, levered equity value,
terminal value, cost of levered equity, cost of unlevered equity.
JEL Classification
M21, M40, M46, M41, G12, G31, J33
Introduction
Practitioners and teachers very easily break some consistency rules when doing or
teaching valuation of assets. In this short and simple note we present a practical guide to
call the attention upon the most frequent broken consistency rules. They have to do firstly
with the consistency in the matching of the cash flows, this is, the free cash flow (FCF), the
cash flow to debt (CFD), the cash flow to equity (CFE), the capital cash flow (CCF) and the
tax savings or tax shield (TS). Secondly, they have to do with the proper expression for the
cost of levered equity, Ke and different formulations for the weighted average cost of
capital, WACC, with finite cash flows and perpetuities. Thirdly, they have to do with the
consistency between the terminal value and growth for the FCF and the terminal value and
growth for the CFE when there is a jump in the CFE due to the adjustment of debt to
comply with the leverage at perpetuity. And finally, the proper determination of the cost of
capital either departing from the cost of unlevered equity (Ku) or the cost of levered equity
(Ke).
This note is organized as follows: In Section One, we present the consistency of
cash flows and values according to the Modigliani and Miller propositions. In Section Two
we define consistency in terms of cash flows and values. In Section Three we show the
different expressions for Ke, traditional WACC and adjusted WACC for perpetuities and
finite cash flows. In Section Four we mention the relationship between the terminal value,
TV for the FCF and the TV for the CFE. In Section Five we show how to proceed for the
estimation of Ku and Ke. In Section Six we conclude. In the Appendixes we derive the
basic algebraic expressions and we illustrate these ideas with a simple example.
2
Section One
The Modigliani–Miller (M&M) Proposal
The basic idea is that the firm value does not depend on how the stakeholders
finance it. This is the stockholders (equity) and creditors (liabilities to banks, bondholders,
etc.) They proposed that with perfect market conditions, (perfect and complete information,
no taxes, etc.) the capital structure does not affect the value of the firm because the equity
holder can borrow and lend and thus determine the optimal amount of leverage. The capital
structure of the firm is the combination of debt and equity in it.
That is, V
L
the value of the levered firm is equal to V
UL
the value of the unlevered firm.
V
L
= V
UL
(1)
And in turn, the value of the levered firm is equal to V
Equity
the value of the equity plus
V
Debt
the value of the debt.
V
L
= V
Equity
+ V
Debt
(2)
This situation happens when no taxes exist. To maintain the equality of the
unlevered and levered firms, the return to the equity holder (levered) must change with the
amount of leverage (assuming that the cost of debt is constant)
When corporate taxes exist (and no personal taxes), the situation posited by M&M
is different. They proposed that when taxes exist the total value of the firm does change.
This occurs because no matter how well managed is the firm if it pays taxes, there exist
what economists call an externality. When the firm deducts any expense, the government
pays a subsidy for the expense. The value of the subsidy is the tax savings. (See Vélez–
Pareja and Tham, 2003)
Hence the value of the firm is increased by the present value of the tax savings or
tax shield.
3
V
L
= V
UL
+ V
TS
(3)
Then, combining equations (2) and (3), we have
V
UL
+ V
TS
= V
Debt
+
V
Equity
(4)
Although we have combined equations (3) and (4), it has to be said that V
Equity
in
equation (2) is different from V
Equity
in equation (4). What we do is to combine the concept
of the equality between levered value, V
L
, and the values of debt and equity.
Each of the values in equation (4) has an associated cash flow as follows:
Table 1. Correspondence between values and cash flows
Market value Cash flow
Assets Free Cash Flow FCF
Debt Cash Flow to Debt CFD
Equity Cash Flow to Equity CFE
Tax savings Cash Flow of TS
According to (4) then the cash flows will be related as
FCF + TS = CFD + CFE (5)
and
FCF = CFD + CFE – TS (6)
This is derived from the following reasoning:
Be X the FCF (identical to the operating profit) for an unlevered firm in perpetuity
and no corporate taxes. Then the value of the firm is
Ku
X
V =
(7a)
Where V is the value of the firm, Ku is the cost of the unlevered equity and X is the
FCF.
If the firm is levered, then the value of debt is
4
Kd
CFD
D =
(7b)
Where D is the market value of debt, CFD is the cash flow to debt and Kd is the
cost of debt.
The CFD is Kd = Kd×D and the CFE is
CFE = NI = X − Kd×D (7c)
Where NI is net income.
Hence, FCF = X = Kd×D + CFE = CFD + CFE (7d)
For an unlevered firm with no corporate taxes then
FCF = CFD + CFE (7e)
If we have taxes, then CFE is
CFE = NI = X − Kd×D − T×(X − Kd×D) = X + T×Kd×D− Kd×D − T×X
= X×(1−T) + T×Kd×D − Kd×D (7f)
Where T is the corporate tax rate.
And this is
CFE = X×(1−T) + T Kd×D− Kd×D = X×(1−T) + TS − CFD
= FCF (after taxes) + TS − CFD (7g)
Or, with taxes taken into account,
FCF + TS = CFD + CFE (7h)
And (7h) is identical to (6)
1
.
The FCF is the amount available for distribution to the capital owners (debt and
equity) after an adjustment for tax savings. The CFE is what the stockholders receive as
1
Although we have presented the value conservation first and the cash flow conservation as derived
from it, the conservation of cash flow is the prior relationship. The value conservation follows from the
conservation of cash flow, not the other way around.
5
dividends or equity repurchase and what they invest in the firm. The CFD is what the firm
receives or pays to the debt holders. The TS is the subsidy the firm receives from the
government for paying interest. The sum of what the owners of the capital is named as
Capital Cash Flow (CCF) and is equal to the sum of the CFD and the CFE.
How do we discount these cash flows? In this table we indicate which discount rate
to use for each cash flow.
Table 2. Correspondence between cash flows and discount rates
Cash flow Discount rate
CFD Cost of debt, Kd
CFE Cost of levered equity, Ke
FCF WACC
TS The appropriate discount rate for TS, ψ
CCF The appropriate discount rate for the CCF
Section Two
Consistency
Our purpose is to provide the correct procedures and expressions for the different
inputs in valuing a cash flow and to guarantee the consistency between the cash flows and
the market values. For consistency we understand the following result:
Total levered value = PV(FCF) = PV(CFE) + Debt = PV(CCF) (8a)
In other words,
Market equity value = Total Levered value – Debt = PV(FCF) − Debt
= PV(CFE) = PV(CCF) − Debt (8b)
Total levered value = APV = PV(FCF at Ku) + PV(TS at ψ) (8c)
These relationships have to hold for any year.
6
Section Three
The Proper Cost of Capital: Which Discount Rate for TS we can Use
In this section we list the proper definitions for Ke and WACC for perpetuities and
finite cash flows taking into account which discount rate we use for TS, ψ. We will
consider only two values for ψ = Ku and Kd.
In the following tables we list the different cases for Ke, traditional WACC and
adjusted WACC. We consider simple perpetuities (no growth), finite cash flows (the most
common situation) and ψ equal to Ku and to Kd. Each of these sets of formulas is presented
to be applied to the FCF, to the CFE and to the CCF.
Applied to the FCF and to the CFE:
The general expression for Ke is
L
1  i
TS
1  i
i i
L
1  i
1  i
i i i i
E
V
) ψ  (Ku 
E
D
) Kd  (Ku Ku Ke + =
(9a)
2
Where Ke is the levered cost of equity, Ku is the unlevered cost of equity, Kd is the
cost of debt, D is the market value of debt, E is the market value of equity, ψ is the discount
rate for the TS and V
TS
is the present value of the TS at ψ.
From this expression we can have the following: the formulation when ψ
i
is Kd or
Ku. If ψ
i
is Ku
i
the third term in the right hand side (RHS) of equation 9a vanishes, and the
expression for Ke is
L
1  i
TS
1  i
i i
L
1  i
1  i
i i i
E
V
) Kd  (Ku 
E
D
) Kd  (Ku Ku +
(9b)
If ψ
i
is Kd
i
then
2
See appendix A for derivation.
7
Ke =
L
1  i
TS
1  i
i i
L
1  i
1  i
i i i
E
V
) Kd  (Ku 
E
D
) Kd  (Ku Ku + (9c)
Now we have to consider two cases: perpetuities (simple) and finite cash flows.
When we have perpetuities, we have to remind that the present value of the
perpetuity for TS is TD because TS is T×Kd×D (T is the corporate tax rate) and the present
value when discounted at Kd is simply T×D. If cash flows are not perpetuities, they are
finite and we have to use expression 9b.
When we simplify 9c for perpetuities and ψ
i
is Kd
i
we have
Ke =
+
L
1  i
TS
1  i
L
1  i
1  i
i i i
E
V

E
D
) Kd  (Ku Ku (9d)
But V
TS
is
TD
Kd
D Kd T
PV(TS) =
× ×
= (9e)
And
Ke =
×
+
L
1  i
1  i
L
1  i
1  i
i i i
E
D T

E
D
) Kd  (Ku Ku (9f)
When we simplifying we obtain
Ke = ( )
L
1  i
1  i
i i i
E
D
T  1 ) Kd  (Ku Ku + (9g)
This is a well known formula for Ke, but it applies only to perpetuities. When we do
not have perpetuities we have to use 9d.
8
Table 3. Return to levered equity Ke according to the Discount rate for TS
ψ
i
= Ku
i
ψ
i
= Kd
i
Perpetuity
E
D
) Kd  (Ku Ku
L
1  i
1  i
i i i
+
( )
E
D
T  1 ) Kd  (Ku Ku
L
1  i
1  i
i i i
+
Finite
E
D
) Kd  (Ku Ku
L
1  i
1  i
i i i
+


.

\

+
L
1  i
TS
1  i
L
1  i
1  i
i i i
E
V

E
D
) Kd  (Ku Ku
When we examine the weighted average cost of capital, WACC, we can handle the
problem in a similar way. The only prevention is to include the proper Ke formulation in its
calculation. Let us call this WACC, WACC for the FCF, WACC
FCF
.
Table 4. Traditional WACC
FCF
formula for the FCF according to the Discount rate for TS
ψ
i
= Ku
i
ψ
i
= d
i
Perpetuity and Finite
( )
L
1  i
1  i i
L
1  i
1  i
i
V
E Ke
V
D
T 1 Kd + − ( )
L
1  i
1  i i
L
1  i
1  i
i
V
E Ke
V
D
T 1 Kd + −
In this traditional formulation V is the market value of the firm; other variables have
been defined above.
We have to warn the reader about the correctness of the traditional WACC. The
previous table shows the typical and best know formulation for WACC, but it has to be said
that this formulation is valid only for a precise and special case: when there is enough
earnings before interest and taxes (EBIT) to earn the TS, that the TS are earned in full and
that taxes are paid the same year as accrued. To cover deviations from this special case we
can use a more general formulation for WACC:
L
1 i
TS
1 i
i i
L
1  i
i
i adjusted
V
V
) ψ [(Ku 
V
TS
 Ku WACC
−
−
− =
(9h)
3
If ψ
i
= Ku
i
the third term in the RHS of equation 9b vanishes. If ψ
i
= Kd
i
reminding
that the present value of the perpetuity for TS is TD and simplifying we obtain
3
See appendix A for derivation.
9
L
1 i
i i
L
1  i
i
i adjusted
V
TD
) Kd [(Ku 
V
TS
 Ku WACC
−
− =
When the discount rate for TS is Kd we have to use 9h. The derivation of the
formulas in the next table can be read in the Appendix.
Table 5. Adjusted WACC
FCF
formula for the FCF according to the Discount rate for TS
ψ
i
= Ku
i
ψ
i
= Kd
i
Simple perpetuities (g=0)
L
1 i
i
i
V
TS
 Ku
−
L
1 i
1  i i
i
V
TD Ku
 Ku
−
Growing perpetuities (g different from 0)
L
V
TS
 Ku
g)  (Kd
g)TD%Kd  (Ku
 Ku
i
i
Finite
L
1 i
i
i
V
TS
 Ku
−
L
1  i
TS
1  i
i i
L
1 i
i
i
V
V
) Kd  (Ku 
V
TS
 Ku
−
Applied to the CCF
Table 6. Traditional WACC formula for the CCF, WACC
CCF
, according to the Discount
rate for TS
ψ
i
= Ku
i
ψ
i
= Kd
i
Perpetuity and Finite
L
1  i
1  i i
L
1  i
1  i i
V
E Ke
V
D Kd
+
L
1  i
1  i i
L
1  i
1  i i
V
E Ke
V
D Kd
+
The general formula for the WACC
CCF
is as follows.
( )
L
1 i
TS
i i i adjusted
V
V
ψ  Ku  Ku WACC
1  i
−
=
(10)
4
Table 7. Adjusted WACC
CCF
formula according to the discount rate for TS
ψ
i
= Ku
i
ψ
i
= Kd
i
Perpetuities Ku
i
( )
L
1 i
i i i
V
TD
Kd  Ku  Ku
−
Finite Ku
i
( )
L
1 i
TS
i i i
V
V
Kd  Ku  Ku
1  i
−
For a detailed derivation of these formulations see Appendix A, Vélez–Pareja and
Tham, 2001 and Tham and Vélez–Pareja 2003.
4
See appendix A for derivation.
10
When the traditional WACC and the adjusted WACC can be used? It depends on
what happens to the tax savings. There are situations when the tax savings cannot be earned
in full a given year due to a very low Earnings Before Interest and Taxes, EBIT, (and there
exist legal provision for losses carried forward, LCF) or the tax savings are not earned in
the current year because taxes are not paid the same year as accrued or there are other
sources different from interest charges that generate tax savings, such as adjustments for
and inflation to the financial statements. (See Vélez–Pareja and Tham, 2003 and Tham and
Vélez–Pareja 2003). When these anomalies occur the traditional formulation for the
traditional WACC cannot be used. This is shown in a simple table below:
Table 8. Conditions for the use of the two versions of WACC
WACC Conditions
Traditional WACC
( )
L
1  i
1  i i
L
1  i
1  i
i
V
E Ke
V
D
T 1 Kd + −
Taxes paid in the same period as accrued.
Enough EBIT to earn the TS. When the only
source of TS is the interest paid.
Adjusted WACC
L
1 i
TS
1 i
i i
L
1  i
i
i adjusted
V
V
) ψ [(Ku 
V
TS
 Ku WACC
−
−
− =
For any situation. However, it is mandatory
when taxes are not paid the same year as
accrued and there is not enough EBIT to earn
the TS. When there are other sources of TS.
Section Four
Relationship between Terminal Value for FCF and Terminal Value for CFE
Case a) Considering only the outstanding debt at year N.
As we mention in Section One the market value for the levered equity is a residual
value. This applies to any point in time. This is, as in stated in equation (8)
Market equity value = Total Levered value – Debt (8)
When this residual relationship is applied to the terminal value, we have
TV for equity = TV for the FCF (for the firm) − Debt (11)
11
This means that we do not need to calculate a growth rate (G) for the CFE.
However, we can derive it departing from the basic residual relationship
5
:
( ) ( )
D
g WACC
g 1 FCF
G K
G 1 CFE
TV
perp e
equity
−
−
+
=
−
+
= (12)
We can solve this expression for G and that would be the consistent growth rate for
the CFE (consistency defined as above).
Multiplying by Ke − G we have
( )
( )
( ) G K D
g WACC
g 1 FCF
G 1 CFE
e
perp
−


.

\

−
−
+
= + (13)
Reorganizing terms, we have
( )
( ) G CFE G K D
g WACC
g 1 FCF
CFE
e
perp
× − −


.

\

−
−
+
= (14)
Grouping terms with G
( ) ( )
G CFE D
g WACC
g 1 FCF
G K D
g WACC
g 1 FCF
CFE
perp
e
perp
× −


.

\

−
−
+
− =


.

\

−
−
+
− (15)
Reorganizing the right hand side and isolating G
( ) ( )


.

\

−


.

\

−
−
+
− =


.

\

−
−
+
− CFE D
g WACC
g 1 FCF
G K D
g WACC
g 1 FCF
CFE
perp
e
perp
(16)
Solving for G
5
In this text we are assuming that the TV is calculated from the FCF just for keeping simple the formulation.
If we wish to keep FCF increasing we have to include some additional investment that takes into account the
depreciation that maintains the level of assets and just keeps the FCF constant and an additional fraction of
the FCF to grant the growth for perpetuity. This is done using the Net operating profit less adjusted taxes.
NOPLAT as a measure of the FCF (this keeps the NOPLAT constant because we are investing the
depreciation) and subtracting a fraction of it related to the return on invested capital, ROIC, (fraction =
g/ROIC) to grant growth.
12
( )
( )


.

\

−


.

\

−
−
+
−


.

\

−
−
+
−
=
CFE D
g WACC
g 1 FCF
K D
g WACC
g 1 FCF
CFE
G
perp
e
perp
(17)
Simplifying
( ) ( ) ( )  
( ) ( ) ( ) g WACC CFE g WACC D g 1 FCF
K g WACC D g 1 FCF g WACC CFE
G
perp perp
e perp perp
− − − + + −
− − + − −
= (18)
Multiplying by −1 the denominator and the numerator and ordering terms we have
( ) ( ) ( )
( ) ( ) g) CFE(WACC g WACC D g 1 FCF
g WACC CFE g WACC DK K g 1 FCF
G
perp perpetuity
perp perp e e
− + − − +
− − − − +
= (19)
This is an awful formula, but consistent. If we set D equal to zero, then CFE is
identical to the FCF and Ke is identical to the WACC and our equation (19) results in
( ) ( )
( )
g
) WACC FCF(1
) WACC g(1 FCF
WACC FCF FCF
g FCF WACC g FCF
g FCF WACC FCF g FCF FCF
g FCF WACC FCF WACC g FCF WACC FCF
g) FCF(WACC g 1 FCF
g WACC FCF WACC g 1 FCF
G
perp
perp
perp
perp
perp
perp perp perp
perpetuity
perp perp
=
+
+ × +
=
× +
× + × × +
=
× − × + × +
× + × − × × + ×
=
− + +
− − +
=
(20)
As expected when D = 0. This is the growth rate for the FCF is the same as the
growth rate for the CFE.
Case b) Considering the level of debt to obtain the perpetual leverage D%
perp
and
using the CFE for N.
We can consider the total debt at year N instead of the debt outstanding from the
forecasting period. This is we can consider the constant leverage for perpetuity, D%
perp
as
13
the basis of our analysis. In this case we have to separate the regular projected CFE and the
extra CFE generated by the adjustment of the current debt to reach the desired D%
perp
. As
we mention in Section One the market value for the levered equity is a residual value. This
applies to any point in time. This is, as in stated in equation (8) but we write that equation
in terms of D%
perp
for year N as
Market equity value = Total Levered value – D%
perp
× TV (8)
When this residual relationship is applied to the terminal value (TV), we have
TV for equity = TV with the NOPLAT (for the firm) × (1 − D%
perp
) (21)
6
This means that we do not need to calculate a growth rate (G) for the CFE.
However, we can derive it departing from the basic residual relationship between values in
equation (21):
( ) ( )
( )
perp
perp e
equity
D% 1
g WACC
g 1 NOPLAT
G K
G 1 CFE
TV −
−
+
=
−
+
= (22)
7
Where WACC
perp
and D%
perp
are the constant WACC and the leverage we define
for perpetuity.
We can solve this expression for G and that would be the consistent growth rate for
the CFE (consistency defined as above).
Multiplying by Ke − G we have
( )
( )
( ) ( ) G K D% 1
g WACC
g 1 FCF
G 1 CFE
e perp
perp
−


.

\

−
−
+
= + (23)
Reorganizing terms, we have
( )
( ) ( ) G CFE G K D% 1
g WACC
g 1 FCF
CFE
e perp
perp
× − −


.

\

−
−
+
= (24)
14
Grouping terms with G
( )
( )
( )
( ) G CFE D% 1
g WACC
g 1 FCF
G K D% 1
g WACC
g 1 FCF
CFE
perp
perp
e perp
perp
× −


.

\

−
−
+
− =


.

\

−
−
+
− (25)
Reorganizing the right hand side and isolating G
( )
( )
( )
( )


.

\

−


.

\

−
−
+
−
=


.

\

−
−
+
−
CFE D% 1
g WACC
g 1 FCF
G
K D% 1
g WACC
g 1 FCF
CFE
perp
perp
e perp
perp
(26)
Solving for G
( )
( )
( )
( )


.

\

−


.

\

−
−
+
−


.

\

−
−
+
−
=
CFE D% 1
g WACC
g 1 FCF
K D% 1
g WACC
g 1 FCF
CFE
G
perp
perp
e perp
perp
(27)
Simplifying
( ) ( )( )  
( )( ) ( ) g WACC CFE D% 1 g 1 FCF
K D% 1 g 1 FCF g WACC CFE
G
perp perp
e perp perp
− − − + −
− + − −
= (28)
Multiplying by −1 the denominator and the numerator and ordering terms we have
( )( ) ( )
( )( ) g) CFE(WACC D% 1 g 1 FCF
g WACC CFE K D% 1 g 1 FCF
G
perp perp
perp e perp
− + − +
− − − +
= (29)
This is also an awful formula, but consistent. If we set D%
perp
equal to zero, then
CFE is identical to the FCF and Ke is identical to the WACC and our equation (29) results
in
15
( ) ( )
( )
g
) WACC FCF(1
) WACC g(1 FCF
WACC FCF FCF
g FCF WACC g FCF
g FCF WACC FCF g FCF FCF
g FCF WACC FCF WACC g FCF WACC FCF
g) FCF(WACC g 1 FCF
g WACC FCF WACC g 1 FCF
G
perp
perp
perp
perp
perp
perp perp perp
perp
perp perp
=
+
+ × +
=
× +
× + × × +
=
× − × + × +
× + × − × × + ×
=
− + +
− − +
=
(30)
As expected when D%
perp
= 0. This is the growth rate for the FCF is the same as the
growth rate for the CFE.
We could proceed the other way around and calculate the growth for the CFE and
derive in a similar fashion g, the growth rate for the FCF. In any case, equation (11) has to
be validated.
As a bottom line, the growth rate for the FCF, g is different than the growth rate for
the CFE, G when we have a change in the level of debt to obtain the desired perpetual
leverage, D%
perp
.
When using this approach we have to take into account that the extra debt (or the
repayment of debt to reach the desired D%
perp
) is a negative (positive) flow in the CFD and
a corresponding positive (negative) flow in the CFE. This amount has to be added
(subtracted) to the TV for the CFE.
Debt value at N = DO at N + New debt (31a)
And new debt ND is
ND = Repurchase of equity = D%
perp
× (TV for CFE + Repurchase of equity + DO at N) −
DO at N (31b)
Solving for Repurchase of equity, RE, we have
16
RE − D%
perp
RE = D%
perp
× (TV for CFE + DO at N) − DO at N (31c)
RE (1 − D%
perp
) = D%
perp
× (TV for CFE + DO at N) − DO at N (31d)
RE = (D%
perp
× (TV for CFE + DO at N) − DO at N)/(1 − D%
perp
) (31e)
But
New Debt = Repurchase of equity (31f)
The new equity at year N will be
Equity at the end of year N = RE + DO (31g)
We have to mention that both approaches, using the growth for CFE, G, with the
debt outstanding or with the perpetual leverage, D%
perp
the results are exactly the same.
This can be seen in Appendix B where we present a numerical example.
In the same line of thought we wish to show that we can use g as the growth rate for
other cash flows, such as the CFD and the TS.
If we set a perpetual level of leverage it means that the relationship between the
value of debt and total levered value using a growing perpetuity is constant and equal to
D%
perp
, the leverage in perpetuity. This is,
g −
+
+
=
perp
D
D
perp
WACC
g) FCF(1
G  Kd
) G CFD(1
D% (32)
Organizing the fractions,
) G  g)(Kd FCF(1
) G g)CFD(1 (WACC
D%
D
D perp
perp
+
+ −
= (33)
( ) ) G g)CFD(1 (WACC ) G  g)(Kd FCF(1 D%
D perp D perp
+ − = + (34)
Developing the operations in (34)
17
( )
g)CFD (WACC G g)CFD (WACC
g) FCF(1 G  g)Kd FCF(1 D%
perp D perp
D perp
− + − =
+ +
(35)
g)CFD (WACC G g)CFD (WACC
g) FCF(1 G D%  g)Kd FCF(1 D%
perp D perp
D perp perp
− + − =
+ +
(36)
Collecting terms with D% to the right hand side of the equation
g)CFD (WACC G g) FCF(1 G D%
g)CFD (WACC  g)Kd FCF(1 D%
perp D D perp
perp perp
− + + =
− +
(37)
Factorizing G
D
( ) g)CFD (WACC g) FCF(1 D% G
g)CFD (WACC  g)Kd FCF(1 D%
perp perp D
perp perp
− + + =
− +
(38)
Solving for G
D
g)CFD (WACC g) FCF(1 D%
g)CFD (WACC  g)Kd FCF(1 D%
G
perp perp
perp perp
D
− + +
− +
= (39)
But we have to remember that CFD is the CFD at period N. Debt at period N is
g −
+
=
perp
WACC
g) FCF(1
D% D (40)
and CFD at period N+1 is
g −
+
perp
WACC
g) FCF(1
g)D%  (Kd (41)
Hence, CFD at period N is
g 1
WACC
g) FCF(1
g)D%  (Kd
perp
+
−
+
g
(42)
and the G
D
is then
18
g 1
WACC
g) FCF(1
g)D%  (Kd
g) (WACC g) FCF(1 D%
g 1
WACC
g) FCF(1
g)D%  (Kd
g) (WACC  g)Kd FCF(1 D%
G
perp
perp perp
perp
perp perp
D
+
−
+
− + +
+
−
+
− +
=
g
g
(43)
Developing the second term in numerator and denominator we have
g 1
g) g)D%FCF(1  (Kd
g) FCF(1 D%
g 1
g) g)D%FCF(1  (Kd
 g)Kd FCF(1 D%
G
perp
perp
D
+
+
+ +
+
+
+
= (44)
Dividing by D%
perp
FCF(1+g) and simplifying we have
g 1
g)  (Kd
1
g 1
g)  (Kd
 Kd
G
D
+
+
+
= (45)
Simplifying,
g)  (Kd g 1
g)  (Kd  g) Kd(1
G
D
+ +
+
= (46)
and
g
Kd 1
g Kdg
G
D
=
+
+
= (47)
Section Five
Starting the Valuation Process and Calculating Ke or Ku as Departing Point
When we value a firm we have to estimate the value of Ke or the value of Ku. See
Vélez–Pareja (2003).
Assume we start with Ku and that the proper discount rate for TS is Ku. Then we
start calculating Ku using some of the methods presented in Vélez–Pareja (2003) or Tham
and Vélez–Pareja (2003): subjectively, unlevering some betas from the market or
unlevering the accounting beta for the firm. For instance, if we unlever the beta for some
firms, we can use CAPM and we calculate Ku.
19
t
t
lev
u
E
D
1
β
β
+
= (48)
where t stands for traded.
Then we calculate Ku as
Ku = R
f
+ βu(Rm – Rf) (49)
With this Ku, we calculate Ke as
E
D
) Kd  (Ku Ku
L
1  i
1  i
i i i
+
(50)
And we can calculate the adjusted WACC as
L
1 i
i
i adjusted
V
TS
 Ku WACC
−
=
(51)
Or the traditional WACC as
WACC = ( )
L
1  i
1  i i
L
1  i
1  i
i
V
E Ke
V
D
T 1 Kd + − (52)
Now assume we start with Ke and that the proper discount rate for TS is Ku.
We calculate Ke using some of the methods presented in Vélez–Pareja (2003) or
Tham and Vélez–Pareja (2003): subjectively, unlevering and levering some betas from the
market or using the accounting beta for the firm. For instance, if we calculate the
accounting beta for the firm, we can use CAPM and we calculate Ke.
Ke = Rf + β
acc
(Rm – Rf) (53)
With this Ke we calculate Ku unlevering the β
acc
as
E
D
1
β
β
acc
u
+
= (54)
20
With this βu we calculate Ku as Ku = Rf + βu(Rm − Rf) and we can calculate the
adjusted WACC as
L
1 i
i
i adjusted
V
TS
 Ku WACC
−
=
(55)
Or with the Ke we calculate the traditional WACC as
WACC = ( )
L
1  i
1  i i
L
1  i
1  i
i
V
E Ke
V
D
T 1 Kd + − (56)
If we start we Ke directly, say, subjectively, we calculate Ku unlevering the beta for Ke
as
β
sub
=
Rf  Rm
Rf  Ke
sub
(57)
and unlever β
sub
as
E
D
1
β
β
sub
u
+
= (58)
and calculate Ku as
Ku = Rf + βu(Rm − Rf) (59)
With Ku we calculate the adjusted WACC as described above.
When we use Ke to derive from it the Ku, we find circularity and that is a problem.
The circularity appears because we have to unlever the Ke with the market value of the firm
and that is what we need to calculate. When we use Ku, it is straightforward.
We cannot have BOTH, Ku and Ke as independent variables. This is, either we
define Ku and we derive Ke using that Ku or we define Ke and from there we derive Ku. In
the valuation of a firm (or a project) we cannot say that we have as inputs Ku AND Ke at
the same time. Given one of them, the other is defined as mentioned above.
21
Section Six
Concluding Remarks
We have presented a summary of the proper relationships for cash flows, terminal
values, cost of capital and a procedure to start the valuation process using Ke or Ku, the
cost of levered equity or the cost of unlevered equity, respectively.
Bibliographic References
Tham, Joseph and Ignacio Velez–Pareja, 2002, An Embarrassment of Riches: Winning
Ways to Value with the WACC, Working Paper in SSRN, Social Science Research
Network.
Tham, Joseph and Ignacio Velez–Pareja, 2004, Principles of Cash Flow Valuation,
Academic Press..
Vélez–Pareja, Ignacio, Cost of Capital for Non–Trading Firms, 2003. In Spanish, in
Academia, Revista Latinoamericana de Administración, de CLADEA Costo de
capital para firmas no transadas en bolsa. No 29, Segundo semestre 2002, pp. 45–
75. Both versions are posted as working papers in SSRN, Social Science Research
Network.
Vélez–Pareja, Ignacio and Joseph Tham, 2001, A Note on the Weighted Average Cost of
Capital WACC, Working Paper in SSRN, Social Science Research Network, In
Spanish as Nota sobre el costo promedio de capital in Monografías No 62, Serie de
Finanzas, La medición del valor y del costo de capital en la empresa, de la Facultad
de Administración de la Universidad de los Andes, Jul. 2002, pp. 61–98. Both
versions are posted as working papers in SSRN, Social Science Research Network.
Vélez–Pareja, Ignacio and Joseph Tham, 2003, Timanco S. A.: Impuestos por pagar,
pérdidas amortizadas, deuda en divisas, renta presuntiva y ajustes por inflación. Su
tratamiento con Flujo de Caja Descontado y EVA©. (Timanco S.A.: Unpaid Taxes,
Losses Carried Forward, Foreign Debt, Presumptive Income and Adjustment for
Inflation. The Treatment with DCF and EVA©), Working Paper in SSRN, Social
Science Research Network.
22
Appendix A
This appendix is based on Tham, Joseph and Ignacio Velez–Pareja, 2002, An
Embarrassment of Riches: Winning Ways to Value with the WACC, Working Paper in
SSRN, Social Science Research Network.
General expression for the return to levered equity Ke
i
We briefly derive the general algebraic expressions for the cost of capital that is
applied to finite cash flows. First, we show that in general, the return to levered equity Ke
i
is a function of ψ
i
, and this is a most important point. Second, we derive the general
expressions for the WACCs.
First, we write the main equations as follows.
V
Un
i1
× (1 + Ku
i
) − V
Un
i
= FCF
i
(A1)
E
L
i1
× (1 + Ke
i
) − E
L
i
= CFE
i
(A2)
D
i1
× (1 + Kd
i
) − D
i
= CFD
i
(A3)
V
TS
i1
× (1 + ψ
i
) − V
TS
i
= TS
i
(A4)
We know that,
FCF
i
+ TS
i
= CFE
i
+ CFD
i
(A5a)
and
V
Un
i
+ V
TS
i
= E
L
i
+ D
i
(A5b)
and
V
Un
i
= E
L
i
+ D
i
− V
TS
i
(A5c)
To obtain the general expression for the Ke, substitute equations A1 to A4 into
equation A5a.
V
Un
i1
× (1 + Ku
i
) − V
Un
i
+ V
TS
i1
× (1 + ψ
i
) − V
TS
i
= E
L
i1
× (1 + Ke
i
) − E
L
i
+ D
i1
× (1 + Kd
i
) − D
i
(A6)
We simplify applying (5b) and obtain,
23
V
Un
i1
× Ku
i
+ V
TS
i1
× ψ
i
= E
L
i1
× Ke
i
+ D
i1
× Kd
i
(A7)
Solve for the return to levered equity and using A5c.
E
L
i1
× Ke
i
= (E
L
i1
+ D
i1
− V
TS
i1
)
× Ku
i
+ V
TS
i1
× ψ
i
− D
i1
× Kd
i
(A8)
Collecting terms and rearranging, we obtain,
E
L
i1
× Ke
i
= E
L
i1
× Ku
i
+ (Ku
i
− Kd
i
)
× D
i1
− (Ku
i
− ψ
i
)
× V
TS
i1
(A9)
Solving for the return to levered equity, we obtain,
L
1  i
TS
1  i
i
L
1  i
1  i
i i i
E
V
ψi)  (Ku
E
D
Kdi)  (Ku Ku Ke − + = (A10)
Adjusted WACC applied to the FCF
We can express the FCF as follows
FCFi = Ku × V
Un
i1
= WACC
i
× V
L
i1
(A11)
Let WACC
Adj
i
be the adjusted WACC that is applied to the FCF in year i.
V
L
i1
× WACC
Adj
i
= D
i1
× Kd
i
– TS
i
+ E
L
i1
× Ke
i
(A12)
V
L
i1
× WACC
Adj
i
= V
Un
i1
× Ku
i
+ V
TS
i1
× ψ
i
– TS
i
(A13)
V
L
i1
× WACC
Adj
i
= (V
L
i1
− V
TS
i1
)
× Ku
i
+ V
TS
i1
× ψ
i
– TS
i
(A14)
V
L
i
1
× WACC
Adj
i
= V
L
i1
× Ku
i
− (Ku
i
 ψ
i
)
× V
TS
i1
– TS
i
(A15)
Solving for the WACC in equation A15, we obtain,
L
1  i
i
L
1  i
TS
1  i
i i
Adj
i
V
TS
V
V
ψ)  (Ku  Ku WACC − = (A16)
Adjusted WACC applied to the CCF
We know that the CCF is equal to the sum of the FCF and the TS.
CCF
i
= CFD
i
+ CFE
i
= FCF
i
+ TS
i
(A17)
Let WACC
Adj
i
be the adjusted WACC applied to the CCF.
V
L
i1
× WACC
Adj
i
= V
Un
i1
× Ku
i
+ V
TS
i1
× ψ
i
(A18)
24
V
L
i1
× WACC
Adj
i
= V
L
i1
× Ku
i
− (Ku
i
− ψ
i
)
× V
TS
i1
(A19a)
Solving for the WACC, we obtain,
=
L
1  i
TS
1  i
i i i
Adj
i
V
V
) ψ  (Ku  Ku WACC (A19b)
Cash flows in perpetuity
Derivation of the adjusted WACC
Assume that the growth rate g > 0 and the CF are in perpetuity. The debt is risk
free, that is Kd = Rf and the leverage θ is constant.
The adjusted WACC applied to the FCF is WACC
perp
.
g  WACC
FCF
V
perp
L
= (A20a)
FCF = V
L
(WACC
perp
– g) (A20b)
g  Ku
FCF
V
Un
= (A21a)
FCF = V
Un
(Ku – g) (A21b)
g −
=
ψ
TS
VTS (A22a)
TS = V
TS
(ψ – g) (A22b)
Where g is the growth rate for TS (and CFD).
Equating equations A20b and A21b, we obtain,
V
L
(WACC
perp
– g) = V
Un
(Ku – g) (A23a)
WACC
perp
V
L
= KuV
Un
– g(V
L
 V
Un
) (A23b)
WACC
perp
V
L
= Ku(V
L
 V
TS
) – g(V
L
 V
Un
) (A23c)
WACC
perp
V
L
= KuV
L
 KuV
TS
– gV
TS
(A23d)
25
WACC
perp
V
L
= KuV
L
 KuV
TS
– gV
TS
(A23e)
L
TS
L
TS
perp
V
gV

V
KuV
 Ku WACC =
(A23f)
L
TS
perp
V
g)V  (Ku
 Ku WACC = (A23g)
There are four cases.
Case 1a: g = 0 and ψ = Ku
perp
L L L
TS
perp
TKdD% Ku
V
TDKd
 Ku
V
TS
 Ku
V
KuV
 Ku WACC − = = = = (A24a)
Case 1b: g = 0 and ψ = Kd

.

\

= = =
L L L
TS
perp
V
TD
 1 Ku
V
KuTD
 Ku
V
KuV
 Ku WACC (A24b)
Case 2a: g > 0 and ψ = Ku
L L L
TS
perp
V
TDKd
 Ku
V
TS
 Ku
V
g)V  (Ku
 Ku WACC = = = (A25a)
Case 2b: g > 0 and ψ = Kd
L L
TS
perp
V
g  Kd
g)TS  (Ku
 Ku
V
g)V  (Ku
 Ku WACC = = (A25b)
WACC
perp
= Ku  [(Ku  g)/(Kd – g)]TDKd/V
L
L
perp
g)V  (Kd
g)TDKd  (Ku
 Ku WACC = (A25c)
26
WACC
perp
=
g)  (Kd
g)TD%Kd  (Ku
 Ku
i
i
(A25d)
Appendix B
In this appendix we show an example to illustrate the ideas presented in the paper.
Case a) Considering only the outstanding debt at year N.
Assume we have the following information:
1. The cost of debt, Kd is constant and equal to 13%. Constant rates for cost of
debt are a simplification; in reality that cost is not constant for several
reasons. One of them is that the firm might have several sources of financial
debt with different rates. The correct way to consider the cost of debt is to
divide the interest charges at the end of the period by the debt balance at the
beginning of the period.
2. The risk free rate, Rf, is 10%.
3. The market risk premium MRP is 5%.
4. The unlevered beta βu is 1.01875.
5. The tax rate is 40% and taxes are paid the same year as accrued. There is
enough EBIT to earn the TS.
6. The growth rate for the FCF is 7%.
7. The desired or expected leverage in perpetuity, constant, is 50%
8. In addition we know that the debt balance and the CFE is as follows
Table A1. Debt balance and CFE
Year 2003 2004 2005 2006 2007 2008
Debt balance 23.08 30.77 38.46 46.15 46.15 46.15
CFE 14.09 16.49 17.49 10.20 11.20
The CFE can be derived from the cash budget looking at the dividends and/or
repurchase of equity and/or new equity investment.
27
From this information we can make some estimates, as follows:
1. We can estimate the unlevered cost of equity, Ku, as follows, using the
CAPM
Ku = Rf + βuMRP = 10% + 1.01875 × 5% = 15.094%
2. The interest payments and the TS can be calculated. The interest charge is I
= Kd × D
t–1
and the TS is T × I. In fact the interest charges can de read
directly from the debt schedule or the cash budget.
Table A2. Interest charges and tax savings
Year 2003 2004 2005 2006 2007 2008
Interest charges 3.00 4.00 5.00 6.00 6.00
TS 1.20 1.60 2.00 2.40 2.40
3. The CFD can be calculated from the debt balance and the interest charges.
The principal payment is the difference between two successive debt
balances, PPMT
t
= D
t–1
– D
t
. In fact, the PPMT can be read directly from the
debt schedule or the cash budget.
Table A3. Debt balance, principal payment, interest and CFD
Year 2003 2004 2005 2006 2007 2008
Debt balance 23.08 30.77 38.46 46.15 46.15 46.15
PPMT –7.69 –7.69 –7.69 0.00 0.00
Interest charges I 3.00 4.00 5.00 6.00 6.00
CFD = PPMT + I −4.69 −3.69 −2.69 6.00 6.00
4. For year N we have two cases: with new debt to reach the D% at perpetuity
in the CFD and without that new debt. With this we have the CFE, the CFD
and the TS, hence we can estimate the FCF and the CCF as follows:
In the first case we have
28
Table A4a. FCF and CCF derived from CFD, CFE and TS for year N
Year 2003 2004 2005 2006 2007 2008
Debt 23.08 30.77 38.46 46.15 46.15 46.15
New debt D% × TV − 46.15
Total debt 23.08 30.77 38.46 46.15 46.15 D% × TV
Interest charges 3.00 4.00 5.00 6.00 6.00
Principal payment –7.69 –7.69 –7.69 0.00 46.15 − D% × TV
Total CFD −4.69 −3.69 −2.69 6.00 6.00 + 46.15 − D% × TV
CFE 14.09 16.49 17.49 10.20 11.20
Repurchase of equity D% × TV − 46.15
Total CFE 14.09 16.49 17.49 10.20 11.20 + D% × TV − 46.15
Sum = CFD + CFE 9.40 12.80 14.80 16.20 17.20
TS 1.20 1.60 2.00 2.40 2.40
FCF = CFD + CFE – TS 8.20 11.20 12.80 13.80 14.80
CCF = CFD + CFE 9.40 12.80 14.80 16.20 17.20
For the second case we have
Table A4b Cash flows not taking into account the new debt
and equity repurchase for year N
2003 2004 2005 2006 2007 2008
Debt at beginning 23.08 30.77 38.46 46.15 46.15 46.15
Interest charges 3.00 4.00 5.00 6.00 6.00
TS 1.20 1.60 2.00 2.40 2.40
Principal payment –7.69 –7.69 –7.69 0.00 0.00
CFD (4.69) (3.69) (2.69) 6.00 6.00
CFE 14.09 16.49 17.49 10.20 11.20
Sum 9.40 12.80 14.80 16.20 17.20
FCF = CFD + CFE – TS 8.20 11.20 12.80 13.80 14.80
CCF = CFD + CFE 9.40 12.80 14.80 16.20 17.20
Observe that the FCF and the CCF are the same no matter which the new debt is and
that the values are independent from including or not the new debt in the analysis.
Finite cash flows and Kd as the discount rate for the TS
Now we will derive the firm and equity values using several methods and assuming
finite cash flows and Kd as the discount rate for the TS.
29
In order to calculate the terminal value TV, for the FCF we have to estimate the
WACC at perpetuity WACC
perp
, given our assumptions. From equation A26d we have
WACC
perp
=
g)  (Kd
g)TD%Kd  (Ku
 Ku
i
i
And then WACC
perp
is
WACC
perp
=
% 59 . 11
7%)  (13%
13% 50% 40% 7%)  (15.09%
 15.09% =
× × ×
On the other hand, the Ke
perp
is
( )
E
D
T  1 ) Kd  (Ku Ku Ke
L
1  i
1  i
i i i perp
+ =
In our example we have
( ) 16.35%
50%  1
50%
40.0%  1 13%.00)  % 09 . 5 (1 % 09 . 5 1 Ke
perp
= + =
On the other hand, the terminal value for the FCF is
g WACC
g) FCF(1
TV
perp
FCF
−
+
=
345,28
% 7 % 59 . 11
%) 7 1 ( 80 . 14
g WACC
g) FCF(1
TV
perp
FCF
=
−
+
=
−
+
=
Using the WACC
adj
,
L
1  i
TS
1  i
i i
L
1 i
i
i
V
V
) Kd  (Ku 
V
TS
 Ku
−
we calculate solving the circularity,
the levered value of the firm and the equity. The present value of the TS is calculated using
Kd as the discount rate. Using (38) to calculate WACC with circularity for the finite cash
flows, we find
30
Table A5. ψ=Kd: Levered values calculated with FCF and Adjusted WACC
Year 2004 2005 2006 2007 2008
FCF 8.20 11.20 12.80 13.80 14.80
TV 345.28
FCF with TV 8.20 11.20 12.80 13.80 360.08
TS 1.20 1.60 2.00 2.40 2.40
Value of TS 6.48 6.12 5.31 4.00 2.12
WACC
adj
14.48% 14.37% 14.29% 14.23% 14.32%
Total levered value 216.6096 239.7686 263.0305 287.8205 314.9796
Levered equity 193.5327 208.9993 224.5690 241.6666 268.8257
Now using the CCF and the WACC
CCF
we calculate the same values. From table 7
we know that the adjusted WACC
CCF
is
( )
L
1 i
TS
i i i
V
V
Kd  Ku  Ku
1  i
−
Table A6. ψ=Kd: Levered values calculated with CCF and WACC for CCF
Year 2003 2004 2005 2006 2007 2008
CCF = FCF + TS
= CFD + CFE
9.40
12.80
14.80
16.20 362.48
TS 1.20 1.60 2.00 2.40 2.40
Value of TS 6.48 6.12 5.31 4.00 2.12
WACC
CCF
=
( )
L
1 i
TS
i i i
V
V
Kd  Ku  Ku
1  i
−
15.03% 15.04% 15.05% 15.06% 15.08%
Total levered value 216.6096 239.7686 263.0305 287.8205 314.9796
Levered equity 193.5327 208.9993 224.5690 241.6666 268.8257
As it should be, the values for the firm and equity match.
As the conditions required for using the traditional WACC formulation and the FCF
are fulfilled, we present the values calculated using it. From Table 3 we know that the
correct formulation for Ke with finite cash flows and Kd as the discount rate for TS is
L
1  i
TS
1  i
i i
L
1  i
1  i
i i i
E
V
) Kd  (Ku 
E
D
) Kd  (Ku Ku +
and the traditional WACC is
( )
L
1  i
1  i i
L
1  i
1  i
i
V
E Ke
V
D
T 1 Kd + −
31
Table A7. ψ=Kd: Levered values calculated with FCF and traditional WACC
Year 2003 2004 2005 2006 2007 2008
FCL
8,20
11,20
12,80
13,80
14,80
TV 345,28
FCF + TV
FCF
8.2
11.2
12.8
13.8
360.1
Kd(1−T) 7.80% 7.80% 7.80% 7.80% 7.80%
Kd(1−T)D% 0.83% 1.00% 1.14% 1.25% 1.14%
TS 1.20 1.60 2.00 2.40 2.40
Value of TS 6.48 6.12 5.31 4.00 2.12
Ke =
L
1  i
TS
1  i
i i L
1  i
1  i
i i i
E
V
) Kd  (Ku 
E
D
) Kd  (Ku Ku +
15.27% 15.34% 15.40% 15.46% 15.44%
KeE% 13.65% 13.37% 13.15% 12.98% 13.17%
Traditional WACC 14.48% 14.37% 14.29% 14.23% 14.32%
Total levered value 216.6096 239.7686 263.0305 287.8205 314.9796
Levered equity 193.5327 208.9993 224.5690 241.6666 268.8257
Again, as expected, the calculated values match.
Now we calculate the TV for the CFE as the TV for the FCF minus the outstanding
debt and the equity value (and total levered value) using the CFE.
Table A8 ψ=Kd: Calculation of levered values using TV
CFE
as TV
FCF
minus debt
2003 2004 2005 2006 2007 2008
CFE 14.09 16.49 17.49 10.20 11.20
TV
CFE
= VT
FCF
− debt 299.12
CFE + VT
CFE
14.09 16.49 17.49 10.20 310.32
TS 1.20 1.60 2.00 2.40 2.40
Value of TS 6.48 6.12 5.31 4.00 2.12
Ke=
L
1  i
TS
1  i
i i L
1  i
1  i
i i i
E
V
) Kd  (Ku 
E
D
) Kd  (Ku Ku +
15.27% 15.34% 15.40% 15.46% 15.44%
Levered equity 193.5327 208.9993 224.5690 241.6666 268.8257
Total levered value 216.6096 239.7686 263.0305 287.8205 314.9796
Again, the values match.
Now we examine the Adjusted Present value approach to check if keeping the
assumptions the values match. We have to realize that the APV when Kd is the discount
rate for TS is identical to the present value of the CCF.
32
Table A9. ψ=Kd: Discount rate Kd: Levered values calculated with APV
Year 2003 2004 2005 2006 2007 2008
FCF with TV
FCF
8.2 11.2 12.8 13.8 422.4
TS 1.20 1.60 2.00 2.40 2.40
PV(FCF at Ku) 210.1340 233.6510 257.7178 283.8170 312.8557
PV(TS at Kd) 6.4757 6.1175 5.3128 4.0034 2.1239
Total APV 216.6096 239.7686 263.0305 287.8205 314.9796
Equity 193.5327 208.9993 224.5690 241.6666 268.8257
Once again the values match because we have used consistent formulations for
every method.
Now using the CFE we will calculate the TV for the CFE and levered equity value.
When we add the debt balance, we obtain the total levered value. Before calculating the
values we have to calculate the terminal value for the CFE, TV
CFE
, and to do that we need
to estimate the growth rate for the CFE, G, or simply subtract from the TV
FCF
the value of
the outstanding debt as we did above. Although it is simpler to subtract the debt from the
TV
FCF
, we will derive the consistent value for G, using equations (19) and (29)
Case a) Considering the debt outstanding at year N and that debt to obtain G, the
growth of the CFE (equation (19)).
( ) ( ) ( )
( ) ( ) g) CFE(WACC g WACC D g 1 FCF
g WACC CFE g WACC DK K g 1 FCF
G
perpetuity perpetuity
perpetuity perpetuity e e
− + − − +
− − − − +
=
and calculating the Ke for perpetuity as
E
D
T)  Kd)(1  (Ku Ku Ke
perp
+ =
As the leverage for perpetuity is 50% the Ke
perp
is
= 15.094% + (15.094% – 13%)(1 – 40%)50%/50% = 16.35%
33
The components of equation (19) are shown in the next table in the order they
appear in the equation. The last column is the sum of the terms at the left.
Table A10. ψ=Kd: Elements to calculate G, the growth for CFE
Term 1 Term 2 Term 3 Sum
Numerator 2.589186 −0.3461012 −0.51368333 1.72940146
Denominator 15.836 −2.11682692 0.51368333 14.2328564
G 12.15%
With this G we calculate the TV
CFE
as
12 . 299
% 15 . 12 % 35 . 16
%) 46 . 13 1 ( 20 . 11
G Ke
G) CFE(1
TV
perp
CFE
=
−
+
=
−
+
=
From Table 3 we know that the formulation for Ke for finite cash flows and Kd as
discount rate for the TS is
L
1  i
TS
1  i
i i
L
1  i
1  i
i i i
E
V
) Kd  (Ku 
E
D
) Kd  (Ku Ku +
Table A11. ψ=Kd: Levered values calculated with CFE and Ke
Year 2003 2004 2005 2006 2007 2008
CFE 14.09 16.49 17.49 10.20 11.20
VT
CFE
299,12
CFE + VT
CFE
14,09 16,49 17,49 10,20 310,32
Value of TS 6.48 6.12 5.31 4.00 2.12
Ke 15,27% 15,34% 15,40% 15,46% 15,44%
Levered equity 193,5327 208,9993 224,5690 241,6666 268,8257
Total levered value 216.6096 239.7686 263.0305 287.8205 314.9796
Once again, the values match as expected.
At this moment we are not surprised that the values match because in all the
methods we have kept the same assumptions and we have used the correct formulations for
each set of assumptions. As we can see, all the calculated values, including the calculations
for the cost of capital match when we use the consistent assumptions and the proper
formulations for each case.
Case b) Considering the level of debt to obtain the perpetual leverage D%
perp
34
In this case we have to consider an additional debt (repayment) to reach the defined
perpetual leverage D%
perp.
This extra debt will be considered as equity repurchase as will be
shown below in Table A13.
Now we have the CFE, the CFD and the TS, hence we can estimate the FCF and the
CCF taking into account that the level of debt at year N is D%
perp
× TV. But this implies to
calculate the terminal value.
Table A12. FCF and CCF derived from CFD, CFE and TS (ψ=Kd)
Year 2003 2004 2005 2006 2007 2008
Debt at beginning 23.08 30.77 38.46 46.15 46.15 46.15
New debt 126.48
Total debt 23.08 30.77 38.46 46.15 46.15 172,64
Interest charges 3.00 4.00 5.00 6.00 6.00
Principal payment −7.69 −7.69 −7.69 0.00 −126,48
Total CFD −4.69 −3.69 −2.69 6.00 −120.48
CFE 14.09 16.49 17.49 10.20 11.20
Repurchase of equity 126.48
Total CFE 14.09 16.49 17.49 10.20 137.68
Sum = CFD + CFE 9.40 12.80 14.80 16.20 17.20
TS 1.20 1.60 2.00 2.40 2.40
FCF = CFD + CFE – TS 8.20 11.20 12.80 13.80 14.80
CCF = FCF + TS 9.40 12.80 14.80 16.20 17.20
If we use the expression for G using D%
perp
instead of D, the outstanding debt in the
forecasting period we apply equation (29).
( )( ) ( )
( )( ) g) CFE(WACC D% 1 g 1 FCF
g WACC CFE K D% 1 g 1 FCF
G
perp perp
perp e perp
− + − +
− − − +
=
We consider that the extra debt (extra payment) is an amount that has to be added
(subtracted) to the terminal value for the CFE. The terminal value for the CFE has to be
calculated always with the CFE before any equity repurchase because that value is the one
generated by the firm to pay to the equity holders.
Applying
35
( )( ) ( )
( )( ) g) CFE(WACC D% 1 g 1 FCF
g WACC CFE K D% 1 g 1 FCF
G
perp perp
perp e perp
− + − +
− − − +
=
we have
Table A13. Calculation of G assuming ψ=Kd
Term 1 Term 2 Sum
Numerator 1.29 0.51368333 0.78
Denominator 7.918 0.51368333 8.43168333
G 9.26%
The calculation for G, the growth for the CFE is made using the expected CFE for
the forecasting period not including the “fictitious” repurchase of equity in year N. With
this G we can calculate the TV for the CFE assuming ψ = Kd. The terminal value for the
CFE is 163.05.
05 . 163
% 46 . 9 % 98 . 16
%) 46 . 9 1 ( 20 . 11
G Ke
G) CFE(1
TV
perp
CFE
=
−
+
=
−
+
=
Then the calculation of the levered equity is
Table A14. Levered values calculated with CFE and Ke using D%
perp
and ψ=Kd
2003 2004 2005 2006 2007 2008
CFE 14.09 16.49 17.49 10.20 11.20
TV
CFE
172.64
Repurchase of equity 126.48
Total CFE = CFE + VT
CFE
14.09 16.49 17.49 10.20 310.32
TS 1.20 1.60 2.00 2.40 2.40
Value of TS 6.48 6.12 5.31 4.00 2.12
Ke 15.27% 15.34% 15.40% 15.46% 15.44%
Levered equity 193.5327 208.9993 224.5690 241.6666 268.8257
Total levered value 216.6096 239.7686 263.0305 287.8205 314.9796
We can compare with the other tables and find that the levered values and the Ke
are identical.
36
At this moment we are not surprised that the values match because in all the
methods we have kept the same assumptions and we have used the correct formulations for
each set of assumptions.
Finite cash flows and Ku as the discount rate for the TS
Now we will derive the firm and equity values using several methods and assuming
finite cash flows and Ku as the discount rate for the TS.
In order to calculate the terminal value TV, for the FCF we have to estimate the
WACC at perpetuity WACC
perp
, given our assumptions. From Table 5 we have
WACC
perp
= % 49 . 12 % 50 % 13 % 40 % 094 . 15 TKdθ  Ku
i
= × × − =
For simplicity and without losing generality, we are assuming that there is no
additional investment at perpetuity.
Hence, the terminal value for the FCF, TV
FCF
, can be calculated as follows
25 . 288
% 7 % 49 . 12
%) 7 1 ( 80 . 14
g WACC
g) FCF(1
TV
perp
FCF
=
−
+
=
−
+
=
Using the WACC
adj
from table 5,
L
1 i
i
i
V
TS
 Ku
−
we calculate solving the circularity, the
levered value of the firm and the equity. Using the data from Table A4b we calculate the
levered values using the FCF and the adjusted WACC.
Table A15. ψ=Ku: Levered values calculated with FCF and Adjusted WACC
Year 2003 2004 2005 2006 2007 2008
FCF 8.20 11.20 12.80 13.80 14.80
TV
FCF
288.25
FCF with TV
FCF
8.20 11.20 12.80 13.80 303.05
TS 1.20 1.60 2.00 2.40 2.40
WACC
adj
=
L
1 i
i
i
V
TS
 Ku
−
14.46% 14.32% 14.21% 14.11% 14.19%
Total levered value 188.0174 206.9963 225.4398 244.6671 265.3965
Levered equity 164.9405 176.2271 186.9782 198.5133 219.2427
37
Now using the CCF and the WACC
CCF
we calculate the same values. From table 6
we know that the WACC
CCF
is K
u
.
Table A16. ψ=Ku: Levered values calculated with CCF and WACC for CCF
Year 2003 2004 2005 2006 2007 2008
CCF 9.40 12.80 14.80 16.20 305.45
WACC
CCF
15.094% 15.094% 15.094% 15.094% 15.094%
Levered value 188.0174 206.9963 225.4398 244.6671 265.3965
Levered equity 164.9405 176.2271 186.9782 198.5133 219.2427
As we expected, the levered values match. It is not strange because we have used
the same assumptions and the correct formulations in each case.
Again, as the conditions required using the traditional WACC formulation and the
FCF, we present the values calculated using it. From Table 3 we know that the correct
formulation for Ke with finite cash flows and Ku as the discount rate for TS is
E
D
) Kd  (Ku Ku
L
1  i
1  i
i i i
+
and the traditional WACC is ( )
L
1  i
1  i i
L
1  i
1  i
i
V
E Ke
V
D
T 1 Kd + − .
Table A17. ψ=Ku: Levered values calculated with FCF and traditional WACC
Year 2003 2004 2005 2006 2007 2008
FCF 8.20 11.20 12.80 13.80 14.80
TV
FCF
288.25
FCF with TV
FCF
8.20 11.20 12.80 13.80 303.05
Kd(1T) 7.80% 7.80% 7.80% 7.80% 7.80%
KdD% 0.96% 1.16% 1.33% 1.47% 1.36%
Ke =
E
D
) Kd  (Ku Ku
L
1  i
1  i
i i i
+
15.39% 15.46% 15.52% 15.58% 15.53%
KeE% 13.50% 13.16% 12.88% 12.64% 12.83%
Traditional WACC 14.46% 14.32% 14.21% 14.11% 14.19%
Levered value 188.0174 206.9963 225.4398 244.6671 265.3965
Levered equity 164.9405 176.2271 186.9782 198.5133 219.2427
As expected, the levered values coincide. Now we calculate the TV for the CFE as
the TV for the FCF minus the outstanding debt and the equity value (and total levered
value) using the CFE.
38
Table A18. ψ=Ku: Levered values with the CFE
2003 2004 2005 2006 2007 2008
CFE 14.09 16.49 17.49 10.20 11.20
TV
CFE
= VT
FCF
− debt
242.10
CFE + VT
CFE
14.0923 16.4923 17.4923 10.2000 253.3010
Ke
E
D
) Kd  (Ku Ku
L
1  i
1  i
i i i
+
15.39% 15.46% 15.52% 15.58% 15.53%
Levered equity
164.9405
176.2271
186.9782
198.5133
219.2427
Total levered value 188.0174 206.9963 225.4398 244.6671 265.3965
Again, the values match.
Now we examine the Adjusted Present value approach to check if keeping the
assumptions the values match. We have to realize that the APV when Ku is the discount
rate for TS is identical to the present value of the CCF.
Table A19. ψ=Ku: Levered values calculated with APV
Year 2003 2004 2005 2006 2007 2008
FCF with TV
FCF
8.20 11.20 12.80 13.80 303.05
TS 1.20 1.60 2.00 2.40 2.40
PV(FCF at Ku) 181.8990 201.1544 220.3161 240.7701 263.3113
PV(TS at Ku) 6.1184 5.8419 5.1237 3.8970 2.0853
Total APV 188.0174 206.9963 225.4398 244.6671 265.3965
Equity 164.9405 176.2271 186.9782 198.5133 219.2427
Once again the values match because we have used consistent formulations for
every method.
Section Six
Now using the CFE we will calculate the TV for the CFE and levered equity value.
When we add the debt balance, we obtain the total levered value. Before calculating the
values we have to calculate the terminal value for the CFE, TV
CFE
, and to do that we need
to estimate the growth rate for the CFE, G, or simply subtract from the TV
FCF
the value of
39
the outstanding debt as we did above. Although it is simpler to subtract the debt from the
TV
FCF
, we will derive the consistent value for G, using equations (19) and (29)
Case a) Considering the debt outstanding at year N and that debt to obtain G, the
growth of the CFE (equation (19)).
( ) ( ) ( )
( ) ( ) g) CFE(WACC g WACC D g 1 FCF
g WACC CFE g WACC DK K g 1 FCF
G
perpetuity perpetuity
perpetuity perpetuity e e
− + − − +
− − − − +
=
and calculating the Ke for perpetuity as
E
D
Kd)  (Ku Ku Ke
perp
+ =
As the leverage for perpetuity is 50% the previous formulation reduces to
Ke
perp
= Ku + (Ku–Kd)D%/E% = 15.094% + (15.094% – 13%)50%/50% = 17.19%
The components of equation (19) are shown in the next table in the order they
appear in the equation. The last column is the sum of the terms at the left.
Table A20. ψ=Ku: Elements to calculate G, the growth for CFE
Term 1 Term 2 Term 3 Sum
Numerator 2.7218125 −0.43580228 −0.6153 1.67071022
Denominator 15.836 −2.53557692 0.6153 13.9157231
G 12.01%
The calculation for G, the growth for the CFE is made using the expected CFE for
the forecasting period not including the “fictitious” repurchase of equity in year N. With
this G we calculate the TV
CFE
as
1010 . 242
% 01 . 12 % 19 . 17
%) 01 . 12 1 ( 20 . 11
G Ke
G) CFE(1
TV
perp
CFE
=
−
+
=
−
+
=
40
From Table 3 we know that the formulation for Ke for finite cash flows and Kd as
discount rate for the TS is
E
D
) Kd  (Ku Ku
L
1  i
1  i
i i i
+ .
Table A21. ψ=Ku: Levered values calculated with CFE and Ke
Year 2003 2004 2005 2006 2007 2008
CFE 14.09 16.49 17.49 10.20 11.20
VT
CFE
242.1010
CFE + TV
CFE
14.0923 16.4923 17.4923 10.2000 253.3010
Ke 15.39% 15.46% 15.52% 15.58% 15.53%
Levered equity 164.9405 176.2271 186.9782 198.5133 219.2427
Levered value 188.0174 206.9963 225.4398 244.6671 265.3965
Once again, the values match as expected.
As we can see, all the calculated values, including the calculations for the cost of
capital match when we use the consistent assumptions and the proper formulations for each
case.
Case b) Considering the level of debt to obtain the perpetual leverage D%
perp
In this case we have to consider an additional debt (repayment) to reach the defined
perpetual leverage D%
perp.
This extra debt will be considered as equity repurchase as will be
shown below in Table A23.
Now we have the CFE, the CFD and the TS, hence we can estimate the FCF and the
CCF taking into account that the level of debt at year N is D%
perp
× TV. But this implies to
calculate the terminal value.
41
Table A22. ψ=Ku: FCF and CCF derived from CFD, CFE and TS
Year 2003 2004 2005 2006 2007 2008
Debt at beginning 23.08 30.77 38.46 46.15 46.15 46.15
New debt 97.97
Total debt 23.08 30.77 38.46 46.15 46.15 144.13
Interest charges 3.000 4.000 5.000 6.000 6.000
Principal payment −7.69 −7.69 −7.69 0.00 −97.97
Total CFD −4.69 −3.69 −2.69 6.00 −91.97
CFE 14.09 16.49 17.49 10.20 11.20
Repurchase of equity 97.97
Total CFE 14.09 16.49 17.49 10.20 109.17
Sum = CFD + CFE 9.40 12.80 14.80 16.20 17.20
TS 1.20 1.60 2.00 2.40 2.40
FCF = CFD + CFE – TS 8.20 11.20 12.80 13.80 14.80
CCF = FCF + TS 9.40 12.80 14.80 16.20 17.20
If we use the expression for G using D%
perp
instead of D, the outstanding debt in the
forecasting period we apply equation (29).
( )( ) ( )
( )( ) g) CFE(WACC D% 1 g 1 FCF
g WACC CFE K D% 1 g 1 FCF
G
perp perp
perp e perp
− + − +
− − − +
=
We consider that the extra debt (extra payment) is an amount that has to be added
(subtracted) to the terminal value for the CFE. The terminal value for the CFE has to be
calculated always with the CFE before any equity repurchase because that value is the one
generated by the firm to pay to the equity holders.
Applying eq (29) we have
Table A23. Calculation of G assuming ψ=Ku
Term 1 Term 2 Sum
Numerator 1.36090625 0.6153 0.74560625
Denominator 7.918 0.6153 8.5333
G 8.74%
42
The calculation for G, the growth for the CFE is made using the expected CFE for
the forecasting period not including the “fictitious” repurchase of equity in year N. With
this G we can calculate the TV for the CFE assuming ψ = Ku. The terminal value is
13 . 144
% 74 . 8 % 19 . 17
%) 74 . 8 1 ( 20 . 11
G Ke
G) CFE(1
TV
perp
CFE
=
−
+
=
−
+
=
Then the calculation of the levered equity is
Table A24. Calculation of levered equity using D%
perp
and ψ=Ku
2003 2004 2005 2006 2007 2008
CFE 14.09 16.49 17.49 10.20 11.20
TV CFE 144.13
Repurchase of equity 97.97
Total CFE 14.0923 16.4923 17.4923 10.2000 253.3010
Ke 15.39% 15.46% 15.52% 15.58% 15.53%
Levered equity 164.9405 176.2271 186.9782 198.5133 219.2427
Total levered value 188.0174 206.9963 225.4398 244.6671 265.3965
We can compare with table A15 and find that the levered values and the Ke are
identical.
With this example we have shown that when done properly, we can arrive to the
correct levered values using the FCF, the CCF or the CFE. When using the CFE we can
derive its terminal value subtracting outstanding debt from the TV for the FCF or
calculating the terminal value for the CFE either taking into account the outstanding debt at
year N or taking into account the total debt as defined by the perpetual leverage, D%
perp
.
From the exploration of the calculated levered values we observe that the values
obtained when we assume Ku as the discount rate are higher than those calculated with Kd
as the discount rate. This is not a surprise because the former does not have the (1 – T)
factor in the calculation of the Ke and this makes the discount rates higher than when we
43
use the (1 – T) factor in the calculation of Ke. The differences between levered values are
as shown in the next table.
Table A25. Differences in using Kd or Ku as assumption regarding the discount rate for TS
Discount rate for TS Kd Ku Difference
Total levered value 216.61 188.02 15.21%
Levered equity 193.53 164.94 17.33%
In pointing out these differences we are not claiming that one assumption is correct
and the other is incorrect. That is a debate that has not concluded.
Abstract Practitioners and teachers very easily break some consistency rules when doing or teaching valuation of assets. In this short and simple note we present a practical guide to call the attention upon the most frequent broken consistency rules. They have to do firstly with the consistency in the matching of the cash flows, this is, the free cash flow (FCF), the cash flow to debt (CFD), the cash flow to equity (CFE) and the tax savings or tax shield (TS). Secondly, they have to do with the proper expression for the cost of unlevered equity with finite cash flows and perpetuities. Thirdly, they have to do with the consistency between the terminal value and growth for the FCF and the terminal value and growth for the CFE, when there is a jump in the CFE due to the adjustment of debt to comply with the leverage at perpetuity. And finally, the proper determination of the cost of capital either departing from the cost of unlevered equity (Ku) or the cost of levered equity (Ke). In the Appendixes we show some algebraic derivations and an example. Key Words Cash flows, free cash flow, cash flow to equity, valuation, levered value, levered equity value, terminal value, cost of levered equity, cost of unlevered equity. JEL Classification M21, M40, M46, M41, G12, G31, J33
ii
Introduction Practitioners and teachers very easily break some consistency rules when doing or teaching valuation of assets. In this short and simple note we present a practical guide to call the attention upon the most frequent broken consistency rules. They have to do firstly with the consistency in the matching of the cash flows, this is, the free cash flow (FCF), the cash flow to debt (CFD), the cash flow to equity (CFE), the capital cash flow (CCF) and the tax savings or tax shield (TS). Secondly, they have to do with the proper expression for the cost of levered equity, Ke and different formulations for the weighted average cost of capital, WACC, with finite cash flows and perpetuities. Thirdly, they have to do with the consistency between the terminal value and growth for the FCF and the terminal value and growth for the CFE when there is a jump in the CFE due to the adjustment of debt to comply with the leverage at perpetuity. And finally, the proper determination of the cost of capital either departing from the cost of unlevered equity (Ku) or the cost of levered equity (Ke). This note is organized as follows: In Section One, we present the consistency of cash flows and values according to the Modigliani and Miller propositions. In Section Two we define consistency in terms of cash flows and values. In Section Three we show the different expressions for Ke, traditional WACC and adjusted WACC for perpetuities and finite cash flows. In Section Four we mention the relationship between the terminal value, TV for the FCF and the TV for the CFE. In Section Five we show how to proceed for the estimation of Ku and Ke. In Section Six we conclude. In the Appendixes we derive the basic algebraic expressions and we illustrate these ideas with a simple example.
Section One The Modigliani–Miller (M&M) Proposal The basic idea is that the firm value does not depend on how the stakeholders finance it. This is the stockholders (equity) and creditors (liabilities to banks, bondholders, etc.) They proposed that with perfect market conditions, (perfect and complete information, no taxes, etc.) the capital structure does not affect the value of the firm because the equity holder can borrow and lend and thus determine the optimal amount of leverage. The capital structure of the firm is the combination of debt and equity in it. That is, VL the value of the levered firm is equal to VUL the value of the unlevered firm. VL = VUL (1)
And in turn, the value of the levered firm is equal to VEquity the value of the equity plus VDebt the value of the debt. VL = VEquity + VDebt (2)
This situation happens when no taxes exist. To maintain the equality of the unlevered and levered firms, the return to the equity holder (levered) must change with the amount of leverage (assuming that the cost of debt is constant) When corporate taxes exist (and no personal taxes), the situation posited by M&M is different. They proposed that when taxes exist the total value of the firm does change. This occurs because no matter how well managed is the firm if it pays taxes, there exist what economists call an externality. When the firm deducts any expense, the government pays a subsidy for the expense. The value of the subsidy is the tax savings. (See Vélez– Pareja and Tham, 2003) Hence the value of the firm is increased by the present value of the tax savings or tax shield. 2
What we do is to combine the concept of the equality between levered value. If the firm is levered. we have VUL + VTS = VDebt + VEquity (3) (4) Although we have combined equations (3) and (4). it has to be said that VEquity in equation (2) is different from VEquity in equation (4). and the values of debt and equity. VL. combining equations (2) and (3). then the value of debt is 3 .VL = VUL + VTS Then. Then the value of the firm is (6) (5) V = X Ku (7a) Where V is the value of the firm. Ku is the cost of the unlevered equity and X is the FCF. Correspondence between values and cash flows Market value Cash flow Assets Free Cash Flow FCF Debt Cash Flow to Debt CFD Equity Cash Flow to Equity CFE Tax savings Cash Flow of TS According to (4) then the cash flows will be related as FCF + TS = CFD + CFE and FCF = CFD + CFE – TS This is derived from the following reasoning: Be X the FCF (identical to the operating profit) for an unlevered firm in perpetuity and no corporate taxes. Each of the values in equation (4) has an associated cash flow as follows: Table 1.
the conservation of cash flow is the prior relationship. Hence. The value conservation follows from the conservation of cash flow. The FCF is the amount available for distribution to the capital owners (debt and equity) after an adjustment for tax savings. The CFD is Kd = Kd×D and the CFE is CFE = NI = X − Kd×D Where NI is net income. FCF + TS = CFD + CFE And (7h) is identical to (6)1. And this is CFE = X×(1−T) + T Kd×D− Kd×D = X×(1−T) + TS − CFD = FCF (after taxes) + TS − CFD Or. not the other way around. with taxes taken into account. 1 (7c) (7d) (7e) (7f) (7g) (7h) 4 . then CFE is CFE = NI = X − Kd×D − T×(X − Kd×D) = X + T×Kd×D− Kd×D − T×X = X×(1−T) + T×Kd×D − Kd×D Where T is the corporate tax rate. FCF = X = Kd×D + CFE = CFD + CFE For an unlevered firm with no corporate taxes then FCF = CFD + CFE If we have taxes. CFD is the cash flow to debt and Kd is the cost of debt. The CFE is what the stockholders receive as Although we have presented the value conservation first and the cash flow conservation as derived from it.D= CFD Kd (7b) Where D is the market value of debt.
Table 2. Market equity value = Total Levered value – Debt = PV(FCF) − Debt = PV(CFE) = PV(CCF) − Debt Total levered value = APV = PV(FCF at Ku) + PV(TS at ψ) These relationships have to hold for any year. The sum of what the owners of the capital is named as Capital Cash Flow (CCF) and is equal to the sum of the CFD and the CFE. Correspondence between cash flows and discount rates Cash flow Discount rate CFD Cost of debt. The TS is the subsidy the firm receives from the government for paying interest. Kd CFE Cost of levered equity. The CFD is what the firm receives or pays to the debt holders.dividends or equity repurchase and what they invest in the firm. (8b) (8c) (8a) 5 . ψ CCF The appropriate discount rate for the CCF Section Two Consistency Our purpose is to provide the correct procedures and expressions for the different inputs in valuing a cash flow and to guarantee the consistency between the cash flows and the market values. How do we discount these cash flows? In this table we indicate which discount rate to use for each cash flow. For consistency we understand the following result: Total levered value = PV(FCF) = PV(CFE) + Debt = PV(CCF) In other words. Ke FCF WACC TS The appropriate discount rate for TS.
In the following tables we list the different cases for Ke.(Ku i . Ku is the unlevered cost of equity. From this expression we can have the following: the formulation when ψi is Kd or Ku. We consider simple perpetuities (no growth). Each of these sets of formulas is presented to be applied to the FCF. D is the market value of debt. 6 . E is the market value of equity. Applied to the FCF and to the CFE: The general expression for Ke is Ke i = Ku i + (Ku i .Kd i ) L . Kd is the cost of debt. If ψi is Kui the third term in the right hand side (RHS) of equation 9a vanishes. ψ. We will consider only two values for ψ = Ku and Kd. traditional WACC and adjusted WACC. ψ is the discount rate for the TS and VTS is the present value of the TS at ψ.(Ku i .ψ i ) iL1 E iL1 E i1 (9a)2 Where Ke is the levered cost of equity.Kd i ) D i1 V TS .Kd i ) L1 E i1 E i1 If ψi is Kdi then (9b) 2 See appendix A for derivation.Section Three The Proper Cost of Capital: Which Discount Rate for TS we can Use In this section we list the proper definitions for Ke and WACC for perpetuities and finite cash flows taking into account which discount rate we use for TS. to the CFE and to the CCF. finite cash flows (the most common situation) and ψ equal to Ku and to Kd. and the expression for Ke is D i1 ViTS Ku i + (Ku i .
7 .T ) D i1 E iL1 (9g) This is a well known formula for Ke. When we do not have perpetuities we have to use 9d. we have to remind that the present value of the perpetuity for TS is TD because TS is T×Kd×D (T is the corporate tax rate) and the present value when discounted at Kd is simply T×D. If cash flows are not perpetuities.(Ku i .Kd i ) D i1 V TS .Kd i ) L1 .Ke = Ku i + (Ku i .iL1 E i1 E i1 (9d) But VTS is PV(TS) = And T × Kd × D = TD Kd (9e) D i T × D i1 Ke = Ku i + (Ku i .Kd i ) iL1 L E i1 E i1 (9c) Now we have to consider two cases: perpetuities (simple) and finite cash flows.Kd i )(1 . but it applies only to perpetuities. When we simplify 9c for perpetuities and ψi is Kdi we have D i V TS Ke = Ku i + (Ku i . When we have perpetuities.Kd i ) L1 E iL1 E i1 (9f) When we simplifying we obtain Ke = Ku i + (Ku i . they are finite and we have to use expression 9b.
WACCFCF. If ψi = Kdi reminding that the present value of the perpetuity for TS is TD and simplifying we obtain 3 See appendix A for derivation. WACC for the FCF. 8 . Traditional WACCFCF formula for the FCF according to the Discount rate for TS ψi = Kui ψi = di D . The previous table shows the typical and best know formulation for WACC.Kd i )(1 .Kd i ) D i 1 E iL1 D i V TS Ku i + (Ku i .Kd i ) L1 Ku i + (Ku i .Kd i ) L1 . Table 4. We have to warn the reader about the correctness of the traditional WACC.T ) L1 Perpetuity E i 1 E i1 Finite Ku i + (Ku i . To cover deviations from this special case we can use a more general formulation for WACC: WACC adjusted TS i ViTS − .iL1 E i1 E i1 When we examine the weighted average cost of capital. we can handle the problem in a similar way.Table 3.Ke i E i1 Kd i (1 − T ) iL1 + Kd i (1 − T ) iL1 + Perpetuity and Finite L Vi1 Vi1 Vi1 ViL1 In this traditional formulation V is the market value of the firm. that the TS are earned in full and that taxes are paid the same year as accrued. WACC.Ke i E i1 D . Return to levered equity Ke according to the Discount rate for TS ψi = Kui ψi = Kdi Di Di Ku i + (Ku i . The only prevention is to include the proper Ke formulation in its calculation. Let us call this WACC.[(Ku i − ψ i ) L1 = Ku i ViL1 Vi −1 (9h)3 If ψi = Kui the third term in the RHS of equation 9b vanishes. but it has to be said that this formulation is valid only for a precise and special case: when there is enough earnings before interest and taxes (EBIT) to earn the TS. other variables have been defined above.
Adjusted WACCFCF formula for the FCF according to the Discount rate for TS ψi = Kui ψi = Kdi Simple perpetuities (g=0) Growing perpetuities (g different from 0) Finite Applied to the CCF Table 6.(Ku i .WACC adjusted = Ku i  TS i TD . Traditional WACC formula for the CCF. Adjusted WACCCCF formula according to the discount rate for TS ψi = Kui ψi = Kdi Perpetuities Finite Kui Kui Ku i . 2001 and Tham and Vélez–Pareja 2003. Vélez–Pareja and Tham. 4 See appendix A for derivation.g)TD%Kd (Kd .[(Ku i − Kd i ) L L Vi1 Vi −1 When the discount rate for TS is Kd we have to use 9h. WACCCCF.Kd i ) i L ViL1 Vi 1 − (10)4 Table 7. 9 . Table 5.Kd i ) V iTS 1 ViL1 − For a detailed derivation of these formulations see Appendix A.(Ku i .g) TS i V TS 1 .Kd i ) TD ViL1 − Ku i . The derivation of the formulas in the next table can be read in the Appendix.(Ku i . according to the Discount rate for TS ψi = Kui ψi = Kdi Kd i D i1 Ke i E i1 Kd i D i1 Ke i E i1 + + Perpetuity and Finite L L Vi1 ViL1 Vi1 ViL1 The general formula for the WACCCCF is as follows. WACC adjusted = Ku i .(Ku i .ψ i ) ViTS 1 V L i −1 Ku i  TS i ViL1 − Ku i  Ku i TD i 1 ViL1 − Ku Ku i  TS VL TS i ViL1 − Ku i Ku i  (Ku i .
For any situation. When these anomalies occur the traditional formulation for the traditional WACC cannot be used. When there are other sources of TS. However. This is shown in a simple table below: Table 8.Ke i E i1 Kd i (1 − T ) iL1 + Vi1 ViL1 Adjusted WACC WACC adjusted = Ku i V TS i . Section Four Relationship between Terminal Value for FCF and Terminal Value for CFE Case a) Considering only the outstanding debt at year N. (and there exist legal provision for losses carried forward. as in stated in equation (8) Market equity value = Total Levered value – Debt When this residual relationship is applied to the terminal value.[(Ku i − ψ i ) L V Vi 1 TS i −1 L i −1 Taxes paid in the same period as accrued. LCF) or the tax savings are not earned in the current year because taxes are not paid the same year as accrued or there are other sources different from interest charges that generate tax savings.When the traditional WACC and the adjusted WACC can be used? It depends on what happens to the tax savings. There are situations when the tax savings cannot be earned in full a given year due to a very low Earnings Before Interest and Taxes. As we mention in Section One the market value for the levered equity is a residual value. 2003 and Tham and Vélez–Pareja 2003). EBIT. we have TV for equity = TV for the FCF (for the firm) − Debt (11) (8) 10 . (See Vélez–Pareja and Tham. Enough EBIT to earn the TS. Conditions for the use of the two versions of WACC WACC Conditions Traditional WACC D . This is. it is mandatory when taxes are not paid the same year as accrued and there is not enough EBIT to earn the TS. such as adjustments for and inflation to the financial statements. This applies to any point in time. When the only source of TS is the interest paid.
However. If we wish to keep FCF increasing we have to include some additional investment that takes into account the depreciation that maintains the level of assets and just keeps the FCF constant and an additional fraction of the FCF to grant the growth for perpetuity. we have FCF(1 + g ) − D (K e − G ) − CFE × G CFE = WACC − g perp Grouping terms with G (14) (13) FCF(1 + g ) FCF(1 + g ) − D K e = −G CFE − − D − CFE × G WACC − g perp WACC perp − g Reorganizing the right hand side and isolating G FCF(1 + g ) FCF(1 + g ) − D K e = G − − D − CFE CFE − WACC − g WACC perp − g perp Solving for G (15) (16) In this text we are assuming that the TV is calculated from the FCF just for keeping simple the formulation. ROIC. we can derive it departing from the basic residual relationship5: TVequity = CFE(1 + G ) FCF(1 + g ) = −D Ke − G WACC perp − g (12) We can solve this expression for G and that would be the consistent growth rate for the CFE (consistency defined as above). This is done using the Net operating profit less adjusted taxes. 5 11 .This means that we do not need to calculate a growth rate (G) for the CFE. NOPLAT as a measure of the FCF (this keeps the NOPLAT constant because we are investing the depreciation) and subtracting a fraction of it related to the return on invested capital. Multiplying by Ke − G we have FCF(1 + g ) − D (K e − G ) CFE(1 + G ) = WACC − g perp Reorganizing terms. (fraction = g/ROIC) to grant growth.
FCF(1 + g ) − D K e CFE − WACC − g perp G= FCF(1 + g ) − − D − CFE WACC perp − g Simplifying (17) G= CFE(WACC perp − g ) − FCF(1 + g ) − D(WACC perp − g ) K e − FCF(1 + g ) + D(WACC perp − g ) − CFE(WACC perp − g ) [ ] (18) Multiplying by −1 the denominator and the numerator and ordering terms we have G= FCF(1 + g )K e − DK e (WACC perp − g ) − CFE(WACC perp − g ) FCF(1 + g ) − D(WACC perpetuity − g ) + CFE(WACC perp − g) (19) This is an awful formula. but consistent. We can consider the total debt at year N instead of the debt outstanding from the forecasting period. This is the growth rate for the FCF is the same as the growth rate for the CFE. Case b) Considering the level of debt to obtain the perpetual leverage D%perp and using the CFE for N. If we set D equal to zero. D%perp as 12 . then CFE is identical to the FCF and Ke is identical to the WACC and our equation (19) results in G= = = = FCF(1 + g )WACC perp − FCF(WACC perp − g ) FCF(1 + g ) + FCF(WACCperpetuity − g) FCF × WACC perp + FCF × g × WACC perp − FCF × WACC perp + FCF × g FCF + FCF × g + FCF × WACC perp − FCF × g + FCF × g × WACC perp + FCF × g FCF + FCF × WACC perp + FCF × g(1 + WACC perp ) FCF(1 + WACC perp ) (20) =g As expected when D = 0. This is we can consider the constant leverage for perpetuity.
the basis of our analysis. This is. we have TV for equity = TV with the NOPLAT (for the firm) × (1 − D%perp) (21)6 This means that we do not need to calculate a growth rate (G) for the CFE. In this case we have to separate the regular projected CFE and the extra CFE generated by the adjustment of the current debt to reach the desired D%perp. We can solve this expression for G and that would be the consistent growth rate for the CFE (consistency defined as above). Multiplying by Ke − G we have FCF(1 + g ) (1 − D% perp )(K e − G ) CFE(1 + G ) = WACC − g perp Reorganizing terms. as in stated in equation (8) but we write that equation in terms of D%perp for year N as Market equity value = Total Levered value – D%perp × TV (8) When this residual relationship is applied to the terminal value (TV). As we mention in Section One the market value for the levered equity is a residual value. This applies to any point in time. However. we can derive it departing from the basic residual relationship between values in equation (21): TVequity = CFE(1 + G ) NOPLAT(1 + g ) (1 − D% perp ) = Ke − G WACC perp − g (22)7 Where WACCperp and D%perp are the constant WACC and the leverage we define for perpetuity. we have FCF(1 + g ) (1 − D% perp )(K e − G ) − CFE × G CFE = WACC − g perp (24) (23) 13 .
If we set D%perp equal to zero. but consistent. then CFE is identical to the FCF and Ke is identical to the WACC and our equation (29) results in 14 .Grouping terms with G FCF(1 + g ) (1 − D% perp )K e = −G FCF(1 + g ) (1 − D% perp ) − CFE × G (25) CFE − WACC − g WACC − g perp perp Reorganizing the right hand side and isolating G FCF(1 + g ) (1 − D% perp )K e = CFE − WACC − g perp FCF(1 + g ) (1 − D% perp ) − CFE G − WACC perp − g Solving for G FCF(1 + g ) (1 − D% perp )K e CFE − WACC − g perp G= FCF(1 + g ) − (1 − D% perp ) − CFE WACC perp − g Simplifying G= CFE (WACC perp − g ) − FCF(1 + g )(1 − D% perp ) K e − FCF(1 + g )(1 − D% perp ) − CFE (WACC perp − g ) (26) (27) [ ] (28) Multiplying by −1 the denominator and the numerator and ordering terms we have G= FCF(1 + g )(1 − D% perp )K e − CFE(WACC perp − g ) FCF(1 + g )(1 − D% perp ) + CFE(WACC perp − g) (29) This is also an awful formula.
Debt value at N = DO at N + New debt And new debt ND is ND = Repurchase of equity = D%perp × (TV for CFE + Repurchase of equity + DO at N) − DO at N Solving for Repurchase of equity.G= = = = FCF(1 + g )WACC perp − FCF(WACC perp − g ) FCF(1 + g ) + FCF(WACC perp − g) FCF × WACC perp + FCF × g × WACC perp − FCF × WACC perp + FCF × g FCF + FCF × g + FCF × WACC perp − FCF × g + FCF × g × WACC perp + FCF × g FCF + FCF × WACC perp + FCF × g(1 + WACC perp ) FCF(1 + WACC perp ) (30) =g As expected when D%perp = 0. This is the growth rate for the FCF is the same as the growth rate for the CFE. the growth rate for the FCF. When using this approach we have to take into account that the extra debt (or the repayment of debt to reach the desired D%perp) is a negative (positive) flow in the CFD and a corresponding positive (negative) flow in the CFE. equation (11) has to be validated. As a bottom line. the growth rate for the FCF. We could proceed the other way around and calculate the growth for the CFE and derive in a similar fashion g. G when we have a change in the level of debt to obtain the desired perpetual leverage. D%perp. we have 15 (31b) (31a) . RE. In any case. g is different than the growth rate for the CFE. This amount has to be added (subtracted) to the TV for the CFE.
G D ) ) = (WACC perp − g)CFD(1 + G D ) Developing the operations in (34) (34) 16 . with the debt outstanding or with the perpetual leverage. D%perp the results are exactly the same. D% perp = (WACC perp − g)CFD(1 + G D ) FCF(1 + g)(Kd . If we set a perpetual level of leverage it means that the relationship between the value of debt and total levered value using a growing perpetuity is constant and equal to D%perp. the leverage in perpetuity. In the same line of thought we wish to show that we can use g as the growth rate for other cash flows. This can be seen in Appendix B where we present a numerical example.RE − D%perp RE = D%perp × (TV for CFE + DO at N) − DO at N RE (1 − D%perp) = D%perp × (TV for CFE + DO at N) − DO at N RE = (D%perp × (TV for CFE + DO at N) − DO at N)/(1 − D%perp) But New Debt = Repurchase of equity The new equity at year N will be Equity at the end of year N = RE + DO (31c) (31d) (31e) (31f) (31g) We have to mention that both approaches. CFD(1 + G D ) Kd .G D ) (33) D% perp (FCF(1 + g)(Kd . using the growth for CFE.G D = FCF(1 + g) WACC perp − g D% perp (32) Organizing the fractions. G. such as the CFD and the TS. This is.
G D FCF(1 + g) ) = (WACC perp − g)CFD + G D (WACC perp − g)CFD D% perp FCF(1 + g)Kd .g)D% FCF(1 + g) WACC perp − g 1+ g and the GD is then (42) 17 .D% perp G D FCF(1 + g) = (WACC perp − g)CFD + G D (WACC perp − g)CFD (35) (36) Collecting terms with D% to the right hand side of the equation D% perp FCF(1 + g)Kd .g)D% FCF(1 + g) WACC perp − g (41) Hence. Debt at period N is D = D% FCF(1 + g) WACC perp − g (40) and CFD at period N+1 is (Kd .(WACC perp − g)CFD D% perp FCF(1 + g) + (WACC perp − g)CFD (39) But we have to remember that CFD is the CFD at period N. CFD at period N is (Kd .(WACC perp − g)CFD = D% perp G D FCF(1 + g) + G D (WACC perp − g)CFD (37) Factorizing GD D% perp FCF(1 + g)Kd .D% perp (FCF(1 + g)Kd .(WACC perp − g)CFD = G D (D% perp FCF(1 + g) + (WACC perp − g)CFD ) (38) Solving for GD GD = D% perp FCF(1 + g)Kd .
(Kd .g) Kd 1+ g GD = (Kd . unlevering some betas from the market or unlevering the accounting beta for the firm. if we unlever the beta for some firms.(WACC perp − g) 1+ g GD = FCF(1 + g) (Kd .g) 1+ 1+ g Simplifying.g) GD = 1 + g + (Kd .g)D%FCF(1 + g) 1+ g GD = (Kd . See Vélez–Pareja (2003). Kd(1 + g) .g)D% WACC perp − g D% perp FCF(1 + g) + (WACC perp − g) 1+ g Developing the second term in numerator and denominator we have (Kd .g)D% WACC perp − g D% perp FCF(1 + g)Kd . we can use CAPM and we calculate Ku. For instance. Assume we start with Ku and that the proper discount rate for TS is Ku. 18 . FCF(1 + g) (Kd .g) and Kdg + g GD = =g 1 + Kd D% perp FCF(1 + g)Kd Section Five (43) (44) (45) (46) (47) Starting the Valuation Process and Calculating Ke or Ku as Departing Point When we value a firm we have to estimate the value of Ke or the value of Ku. Then we start calculating Ku using some of the methods presented in Vélez–Pareja (2003) or Tham and Vélez–Pareja (2003): subjectively.g)D%FCF(1 + g) D% perp FCF(1 + g) + 1+ g Dividing by D%perpFCF(1+g) and simplifying we have (Kd .
We calculate Ke using some of the methods presented in Vélez–Pareja (2003) or Tham and Vélez–Pareja (2003): subjectively. if we calculate the accounting beta for the firm.βu = β lev D 1+ t Et (48) where t stands for traded. Then we calculate Ku as Ku = Rf + βu(Rm – Rf) With this Ku. we calculate Ke as Ku i + (Ku i . unlevering and levering some betas from the market or using the accounting beta for the firm. we can use CAPM and we calculate Ke. Ke = Rf + βacc(Rm – Rf) With this Ke we calculate Ku unlevering the βacc as βu = β acc D 1+ E (53) (54) 19 .Kd i ) D i 1 E iL1 (49) (50) And we can calculate the adjusted WACC as WACC adjusted = Ku i TS i ViL1 − (51) Or the traditional WACC as WACC = Kd i (1 − T ) D i1 Ke i E i1 + ViL1 ViL1  (52) Now assume we start with Ke and that the proper discount rate for TS is Ku. For instance.
we calculate Ku unlevering the beta for Ke as βsub = Ke sub . Given one of them. When we use Ku. subjectively. it is straightforward. In the valuation of a firm (or a project) we cannot say that we have as inputs Ku AND Ke at the same time. we find circularity and that is a problem.Rf (57) and unlever βsub as βu = β sub D 1+ E (58) and calculate Ku as Ku = Rf + βu(Rm − Rf) With Ku we calculate the adjusted WACC as described above. Ku and Ke as independent variables. This is.With this βu we calculate Ku as Ku = Rf + βu(Rm − Rf) and we can calculate the adjusted WACC as WACC adjusted = Ku i TS i ViL1 − (55) Or with the Ke we calculate the traditional WACC as WACC = Kd i (1 − T ) D i1 Ke i E i1 + ViL1 ViL1  (56) If we start we Ke directly. We cannot have BOTH. either we define Ku and we derive Ke using that Ku or we define Ke and from there we derive Ku. When we use Ke to derive from it the Ku.Rf Rm . the other is defined as mentioned above. 20 (59) . say. The circularity appears because we have to unlever the Ke with the market value of the firm and that is what we need to calculate.
Working Paper in SSRN. Losses Carried Forward. de la Facultad de Administración de la Universidad de los Andes. A Note on the Weighted Average Cost of Capital WACC. 2003. pp. 61–98. Ignacio. Joseph and Ignacio Velez–Pareja. Serie de Finanzas. 45– 75. Presumptive Income and Adjustment for Inflation. Ignacio and Joseph Tham.. Timanco S. Principles of Cash Flow Valuation.: Impuestos por pagar. renta presuntiva y ajustes por inflación. Social Science Research Network. Joseph and Ignacio Velez–Pareja. Su tratamiento con Flujo de Caja Descontado y EVA©. Social Science Research Network. pp. Cost of Capital for Non–Trading Firms. Jul. Working Paper in SSRN. The Treatment with DCF and EVA©). 2002. La medición del valor y del costo de capital en la empresa. Segundo semestre 2002. Both versions are posted as working papers in SSRN. Foreign Debt. Social Science Research Network.Section Six Concluding Remarks We have presented a summary of the proper relationships for cash flows. Social Science Research Network. (Timanco S. Tham. Revista Latinoamericana de Administración. de CLADEA Costo de capital para firmas no transadas en bolsa. Vélez–Pareja. pérdidas amortizadas. Vélez–Pareja. 21 . No 29. In Spanish as Nota sobre el costo promedio de capital in Monografías No 62.: Unpaid Taxes. Both versions are posted as working papers in SSRN. Ignacio and Joseph Tham. in Academia. 2003. cost of capital and a procedure to start the valuation process using Ke or Ku. Working Paper in SSRN. An Embarrassment of Riches: Winning Ways to Value with the WACC. respectively. A. the cost of levered equity or the cost of unlevered equity. terminal values. 2004. Vélez–Pareja. Academic Press. Social Science Research Network. deuda en divisas.A. In Spanish. 2001. Bibliographic References Tham. 2002.
Social Science Research Network. First. 2002. and this is a most important point. VUni1 × (1 + Kui) − VUni = FCFi ELi1 × (1 + Kei) − ELi = CFEi Di1 × (1 + Kdi) − Di = CFDi VTSi1 × (1 + ψi) − VTSi = TSi We know that.Appendix A This appendix is based on Tham. 22 (A6) . we show that in general. Working Paper in SSRN. FCFi + TSi = CFEi + CFDi and VUni + VTSi = ELi + Di and VUni = ELi + Di − VTSi (A5c) (A5b) (A1) (A2) (A3) (A4) (A5a) To obtain the general expression for the Ke. the return to levered equity Kei is a function of ψi. Second. substitute equations A1 to A4 into equation A5a. VUni1 × (1 + Kui) − VUni + VTSi1 × (1 + ψi) − VTSi = ELi1 × (1 + Kei) − ELi + Di1 × (1 + Kdi) − Di We simplify applying (5b) and obtain. Joseph and Ignacio Velez–Pareja. An Embarrassment of Riches: Winning Ways to Value with the WACC. we write the main equations as follows. First. General expression for the return to levered equity Kei We briefly derive the general algebraic expressions for the cost of capital that is applied to finite cash flows. we derive the general expressions for the WACCs.
ψ) ViTS TS i 1 − ViL1 ViL1 (A16) (A12) (A13) (A14) (A15) Adjusted WACC applied to the CCF We know that the CCF is equal to the sum of the FCF and the TS. Ke i = Ku i + (Ku i .(Ku i . WACC iAdj = Ku i .VUni1 × Kui + VTSi1 × ψi = ELi1 × Kei + Di1 × Kdi Solve for the return to levered equity and using A5c.Kdi) VD i1 − (Ku i . we obtain.ψi) iL1 E iL1 E i1 Adjusted WACC applied to the FCF We can express the FCF as follows FCFi = Ku × VUni1 = WACCi × VLi1 (A11) Let WACCAdji be the adjusted WACC that is applied to the FCF in year i. VLi1 × WACCAdji = Di1 × Kdi – TSi + ELi1 × Kei VLi1 × WACCAdji = VUni1 × Kui + VTSi1 × ψi – TSi VLi1 × WACCAdji = (VLi1 − VTSi1) × Kui + VTSi1 × ψi – TSi VLi1 × WACCAdji = VLi1 × Kui − (Kui . we (A10) obtain. CCFi = CFDi + CFEi = FCFi + TSi Let WACCAdji be the adjusted WACC applied to the CCF. (A7) ELi1 × Kei = (ELi1 + Di1 − VTSi1) × Kui + VTSi1 × ψi − Di1 × Kdi (A8) Collecting terms and rearranging. VLi1 × WACCAdji = VUni1 × Kui + VTSi1 × ψi (A17) (A18) 23 . ELi1 × Kei = ELi1 × Kui + (Kui − Kdi) × Di1 − (Kui − ψi) × VTSi1 (A9) Solving for the return to TS levered equity. we obtain.ψi) × VTSi1 – TSi Solving for the WACC in equation A15.
that is Kd = Rf and the leverage θ is constant.g FCF = VUn(Ku – g) VTS = TS ψ−g TS = VTS(ψ – g) Where g is the growth rate for TS (and CFD).VLi1 × WACCAdji = VLi1 × Kui − (Kui − ψi) × VTSi1 Solving for the WACC. we obtain.ψ i ) L Vi1 (A19b) Cash flows in perpetuity Derivation of the adjusted WACC Assume that the growth rate g > 0 and the CF are in perpetuity. The debt is riskfree. VL(WACCperp – g) = VUn(Ku – g) WACCperpVL = KuVUn – g(VL .(Ku i . Equating equations A20b and A21b. WACC Adj i (A19a) ViTS 1 = Ku i .VUn) WACCperp VL = KuVL . The adjusted WACC applied to the FCF is WACCperp.VTS) – g(VL .KuVTS – gVTS (A23a) (A23b) (A23c) (A23d) 24 .g (A20a) (A20b) (A21a) (A21b) (A22a) (A22b) FCF = VL(WACCperp – g) V Un = FCF Ku .VUn) WACCperpVL = Ku(VL . we obtain. VL = FCF WACC perp .
g)V TS VL (A23e) (A23f) WACC perp = Ku  (A23g) There are four cases.L VL V (Ku .g)V VL TS (A25b) WACCperp = Ku .KuVTS – gVTS WACC perp = Ku KuV TS gV TS .L = Ku = Ku − TKdD% perp L V V VL (A24a) Case 1b: g = 0 and ψ = Kd WACC perp = Ku KuTD KuV TS TD = Ku = Ku1 .L = Ku L V V VL (A25a) Case 2b: g > 0 and ψ = Kd (Ku .g)TDKd (Kd .g)V L (A25c) 25 .[(Ku .g)TS Kd . Case 1a: g = 0 and ψ = Ku WACC perp = Ku KuV TS TS TDKd = Ku .WACCperp VL = KuVL .L L L V V V (A24b) Case 2a: g > 0 and ψ = Ku WACC perp (Ku .g)V TS TS TDKd = Ku = Ku .g = Ku VL WACC perp = Ku  (Ku .g)/(Kd – g)]TDKd/VL WACC perp = Ku (Ku .
(Ku i . The tax rate is 40% and taxes are paid the same year as accrued. Case a) Considering only the outstanding debt at year N.49 17. Kd is constant and equal to 13%. The market risk premium MRP is 5%.g) (A25d) Appendix B In this appendix we show an example to illustrate the ideas presented in the paper. Debt balance and CFE Year 2003 2004 2005 2006 2007 Debt balance 23.20 the dividends and/or . 4.15 CFE 14. The desired or expected leverage in perpetuity. 6. 3.g)TD%Kd (Kd .15 11.20 The CFE can be derived from the cash budget looking at repurchase of equity and/or new equity investment. 5. is 10%. The growth rate for the FCF is 7%.08 30. The cost of debt. The unlevered beta βu is 1. In addition we know that the debt balance and the CFE is as follows Table A1.77 38.15 46. One of them is that the firm might have several sources of financial debt with different rates.WACCperp = Ku i . 26 2008 46. Constant rates for cost of debt are a simplification. There is enough EBIT to earn the TS. 7.01875. is 50% 8. Assume we have the following information: 1. The risk free rate. 2.09 16. Rf. The correct way to consider the cost of debt is to divide the interest charges at the end of the period by the debt balance at the beginning of the period.46 46. in reality that cost is not constant for several reasons.49 10. constant.
00 2.00 Interest charges I 3.40 3.00 TS 1.00 4. Table A3.00 5. hence we can estimate the FCF and the CCF as follows: In the first case we have 27 .15 PPMT –7. Interest charges and tax savings Year 2003 2004 2005 2006 2007 2008 Interest charges 3. The interest payments and the TS can be calculated.00 CFD = PPMT + I −4.69 0. as follows: 1.15 46.08 30. In fact the interest charges can de read directly from the debt schedule or the cash budget. Ku.69 6. In fact. using the CAPM Ku = Rf + βuMRP = 10% + 1. interest and CFD Year 2003 2004 2005 2006 2007 2008 Debt balance 23. The interest charge is I = Kd × Dt–1 and the TS is T × I.00 0.60 2. PPMTt = Dt–1 – Dt.69 –7. the CFD and the TS.77 38.01875 × 5% = 15.00 6. The CFD can be calculated from the debt balance and the interest charges. Table A2.00 5.00 6.69 −2.69 –7.46 46. The principal payment is the difference between two successive debt balances. For year N we have two cases: with new debt to reach the D% at perpetuity in the CFD and without that new debt.20 1. With this we have the CFE. the PPMT can be read directly from the debt schedule or the cash budget.00 4. principal payment.From this information we can make some estimates.00 6.69 −3. We can estimate the unlevered cost of equity.00 6.094% 2.40 2. as follows.15 46.00 4. Debt balance.00 6.
40 1.80 16.15 46.00 2.Table A4a.00 6.09 16.20 Observe that the FCF and the CCF are the same no matter which the new debt is and that the values are independent from including or not the new debt in the analysis.00 6.46 46.15 46.00 46.00 6.80 13.80 16.08 30. FCF and CCF derived from CFD.15 Total CFE 14.40 2.69 (3.40 FCF = CFD + CFE – TS 8.80 14.00 10.80 CCF = CFD + CFE 9.40 8.00 4.80 14.20 17.20 TS 1.60 2.80 2.80 2.15 New debt D% × TV − 46.00 6.00 –7.00 6.77 38.08 30.20 9.69 –7.80 17.49 17.20 11.15 6.69 –7.00 4.49 10.15 46.69) 14.60 –7.00 6.40 0.20 Repurchase of equity D% × TV − 46.20 2008 46.49 14.08 30. Finite cash flows and Kd as the discount rate for the TS Now we will derive the firm and equity values using several methods and assuming finite cash flows and Kd as the discount rate for the TS.69 −3.49 12.80 14.80 12.15 D% × TV Interest charges 3.15 Total debt 23.15 Sum = CFD + CFE 9.00 Principal payment –7.20 –7.80 16.46 46.20 1.69 6.20 14.20 For the second case we have Table A4b Cash flows not taking into account the new debt and equity repurchase for year N 2003 2004 2005 2006 2007 Debt at beginning 23.46 46.40 12.69 −2.15 − D% × TV Total CFD −4.80 14.40 12.20 17.69) 16.00 5.40 0.69 0.49 10.69 (2.00 TS Principal payment CFD CFE Sum FCF = CFD + CFE – TS CCF = CFD + CFE 1.09 9.80 11.49 17.20 12. CFE and TS for year N Year 2003 2004 2005 2006 2007 2008 Debt 23.15 46.20 16.77 38.20 + D% × TV − 46.15 − D% × TV CFE 14.20 13.69 (4. 28 .77 38.09 16.00 11.00 2.69) 17.20 12.20 17.20 11.00 5.15 Interest charges 3.00 + 46.20 11.
The present value of the TS is calculated using Kd as the discount rate.59% (13% . given our assumptions.(15. for the FCF we have to estimate the WACC at perpetuity WACCperp. we find 29 .T ) D i1 E iL1 In our example we have Ke perp = 15. Ku i .Kd i )(1 .13%.80(1 + 7%) = = 345.28 WACC perp − g 11.TS i . the Keperp is Ke perp = Ku i + (Ku i .Kd i ) Vi 1 we calculate solving the circularity.09% .50% On the other hand. From equation A26d we have WACCperp = Ku i .40. Using (38) to calculate WACC with circularity for the finite cash flows. L L Vi −1 Vi 1 the levered value of the firm and the equity.(Ku i .09% + (15.g) And then WACCperp is WACCperp = 15.0% ) 50% = 16.35% 1 .09% .7%) On the other hand.09% .(Ku i .7%) × 40% × 50% × 13% = 11.59% − 7% TVFCF = TS Using the WACCadj.00)(1 .g)TD%Kd (Kd .In order to calculate the terminal value TV. the terminal value for the FCF is TVFCF = FCF(1 + g) WACC perp − g FCF(1 + g) 14.
(Ku i .9796 268.20 1.8205 Levered equity 193.5690 241.80 14.60 2. From table 7 we know that the adjusted WACCCCF is Ku i .04% 15.05% Total levered value 216.20 12. ψ=Kd: Levered values calculated with CCF and WACC for CCF Year 2003 2004 2005 2006 2007 2008 CCF = FCF + TS = CFD + CFE 9.6666 As it should be.20 362.8257 2008 14.6666 268.0305 287.20 1.60 2.80 TV FCF with TV 8.20 11. From Table 3 we know that the correct formulation for Ke with finite cash flows and Kd as the discount rate for TS is D i1 ViTS Ku i + (Ku i .48 6.40 Value of TS 6.9796 Levered equity 193.(Ku i .31 4.12 WACCCCF = 15.03% 15.8205 314.06% 314.80 345.00 2.37% 14.6096 239.5327 208.08 2.Kd i ) L1 E i1 E i1 Kd i (1 − T ) D i1 Ke i E i1 + ViL1 ViL1  and the traditional WACC is 30 .12 5.32% Now using the CCF and the WACCCCF we calculate the same values. ViL1 − Ku i .Table A5.8257 15.Kd i ) L .12 WACCadj 14.23% Total levered value 216.0305 287.80 13.48% 14.31 4.5327 208.08% As the conditions required for using the traditional WACC formulation and the FCF are fulfilled.48 6.(Ku i .80 16. ψ=Kd: Levered values calculated with FCF and Adjusted WACC Year 2004 2005 2006 2007 FCF 8.20 11.80 13.29% 14.40 14.Kd i ) V iTS 1 15.5690 241.48 TS 1.28 360.7686 263.9993 224.40 Value of TS 6. the values for the firm and equity match.80 TS 1.9993 224.12 5.00 2.40 12.00 2.Kd i ) V L TS i 1 Vi −1 Table A6.6096 239.40 2.20 12. we present the values calculated using it.7686 263.00 2.
Table A8 ψ=Kd: Calculation of levered values using TVCFE as TVFCF minus debt 2003 2004 2005 2006 2007 2008 CFE 14.14% 2.Kd i ) 8.12 14.20 TVCFE = VTFCF − debt 299.40 6.2 7.40% 15.40 2.7686 263.2 7.17% 14. 31 .5327 208.60 5.34% 15.44% E E Levered equity 193.44% 13.46% 15.09 16.00 4.80 13.7686 263.8 7.6666 268.37% 14. the calculated values match.00 13.25% 2.28 360.00% 1.32% Again.27% 15.12 CFE + VTCFE 14.0305 287.Kd ) .49 10.31 4.49 17.34% 15.14% 2.(Ku .9796 i i i i 1 L i 1 i i TS i 1 L i 1 Again.48% 14.65% 13.40 2.49 17.29% 14.20 1.15% 12.40 Value of TS 6.1 7.8205 314.20 11.Kd i ) iL1 E iL1 E i 1 15.37% 13.48 6.49 10.48 KeE% Traditional WACC Total levered value Levered equity D i 1 V TS .6666 268.8257 15.60 2.00 2.12 11.98% 14.27% 15.9993 224.6096 239.12 5.80 345. as expected.20 11.80% 1.9993 224. the values match.80% 0.80 12.9796 193.20 310.80% 1.40% 15.20 6.12 Ke= D V Ku + (Ku .8257 Total levered value 216.80% 1.46% 13.00 2.23% 216.5327 208.32 TS 1. We have to realize that the APV when Kd is the discount rate for TS is identical to the present value of the CCF.Kd ) 15. Now we examine the Adjusted Present value approach to check if keeping the assumptions the values match.09 16. ψ=Kd: Levered values calculated with FCF and traditional WACC Year 2003 2004 2005 2006 2007 2008 FCL TV FCF + TVFCF Kd(1−T) Kd(1−T)D% TS Value of TS Ke = Ku i + (Ku i .31 12.83% 1.8 7.Table A7.20 8.(Ku i .80% 1.8205 314.6096 239. Now we calculate the TV for the CFE as the TV for the FCF minus the outstanding debt and the equity value (and total levered value) using the CFE.5690 241.5690 241.0305 287.
using equations (19) and (29) Case a) Considering the debt outstanding at year N and that debt to obtain G.7686 263.1239 Total APV 216. and to do that we need to estimate the growth rate for the CFE.T) D E As the leverage for perpetuity is 50% the Keperp is = 15.0305 287. Now using the CFE we will calculate the TV for the CFE and levered equity value.8257 Once again the values match because we have used consistent formulations for every method.6096 239.5690 241.2 12.5327 208. G.Kd)(1 . When we add the debt balance. ψ=Kd: Discount rate Kd: Levered values calculated with APV Year 2003 2004 2005 2006 2007 2008 FCF with TVFCF 8. we will derive the consistent value for G.40 PV(FCF at Ku) 210.4757 6.8205 314.40 2. Before calculating the values we have to calculate the terminal value for the CFE.Table A9.1175 5.4 TS 1.8 422. TVCFE.7178 283.0034 2.8170 312.60 2.9796 Equity 193.35% 32 .6666 268.3128 4.8557 PV(TS at Kd) 6. or simply subtract from the TVFCF the value of the outstanding debt as we did above.8 13. G= FCF(1 + g )K e − DK e (WACC perpetuity − g ) − CFE(WACC perpetuity − g ) FCF(1 + g ) − D(WACC perpetuity − g ) + CFE(WACC perpetuity − g) and calculating the Ke for perpetuity as Ke perp = Ku + (Ku . Although it is simpler to subtract the debt from the TVFCF.20 1.6510 257. we obtain the total levered value.1340 233.9993 224.094% – 13%)(1 – 40%)50%/50% = 16.00 2.2 11.094% + (15. the growth of the CFE (equation (19)).
31 15.34% 224. the values match as expected.8257 314.8205 10.12 15.27% 208.12 15.15% With this G we calculate the TVCFE as TVCFE = CFE(1 + G) 11.72940146 Denominator 15.49 17.12 310.5690 263.836 −2.0305 17.46% 268.09 6.3461012 −0.20 6.7686 16.Kd i ) iL1 L E i1 E i1 2008 11.09 16. all the calculated values.48 193.11682692 0. ψ=Kd: Levered values calculated with CFE and Ke Year 2003 2004 2005 2006 2007 14. As we can see.00 15.20(1 + 13.32 15. At this moment we are not surprised that the values match because in all the methods we have kept the same assumptions and we have used the correct formulations for each set of assumptions.20 299.5327 216. ψ=Kd: Elements to calculate G.9993 239.6096 14.51368333 1.20 2.9796 Once again.2328564 G 12. including the calculations for the cost of capital match when we use the consistent assumptions and the proper formulations for each case.15% From Table 3 we know that the formulation for Ke for finite cash flows and Kd as discount rate for the TS is Ku i + (Ku i .12 Ke perp − G 16.44% CFE VTCFE CFE + VTCFE Value of TS Ke Levered equity Total levered value Table A11.49 10.51368333 14.589186 −0.(Ku i . Case b) Considering the level of debt to obtain the perpetual leverage D%perp 33 .46%) = = 299.49 5.35% − 12. the growth for CFE Term 1 Term 2 Term 3 Sum Numerator 2.Kd i ) D i1 V TS .The components of equation (19) are shown in the next table in the order they appear in the equation. The last column is the sum of the terms at the left.6666 287.49 4. Table A10.40% 241.
46 46.15 New debt 126.49 10. The terminal value for the CFE has to be calculated always with the CFE before any equity repurchase because that value is the one generated by the firm to pay to the equity holders. CFE and TS (ψ=Kd) Year 2003 2004 2005 2006 2007 2008 Debt at beginning 23.68 Sum = CFD + CFE 9.48 Total CFE 14.48 Total debt 23.20 137.20 12.20 11. hence we can estimate the FCF and the CCF taking into account that the level of debt at year N is D%perp × TV.69 0.40 12. Applying 34 . G= FCF(1 + g )(1 − D% perp )K e − CFE(WACC perp − g ) FCF(1 + g )(1 − D% perp ) + CFE(WACC perp − g) We consider that the extra debt (extra payment) is an amount that has to be added (subtracted) to the terminal value for the CFE.20 TS 1.40 2. FCF and CCF derived from CFD.40 FCF = CFD + CFE – TS 8.80 16.15 172.00 6.20 17.09 16.80 14.46 46.20 1.48 Total CFD −4.80 14.69 −7.20 17.80 13.08 30.77 38.40 12.15 46. Now we have the CFE.48 CFE 14.80 CCF = FCF + TS 9. This extra debt will be considered as equity repurchase as will be shown below in Table A13.20 Repurchase of equity 126.00 2.69 −7.00 5.80 16.09 16.60 2.00 −120.In this case we have to consider an additional debt (repayment) to reach the defined perpetual leverage D%perp. Table A12.08 30.64 Interest charges 3.49 17.49 17.00 Principal payment −7.15 46.69 −3.20 11.77 38.80 14. the outstanding debt in the forecasting period we apply equation (29).00 6.69 −2. But this implies to calculate the terminal value. the CFD and the TS.15 46.20 If we use the expression for G using D%perp instead of D.49 10.00 −126.69 6.00 4.
51368333 8.6096 239.49 10.40% 15.49 17.34% 15.5690 241. Levered values calculated with CFE and Ke using D%perp and ψ=Kd 2003 CFE TVCFE Repurchase of equity Total CFE = CFE + VTCFE TS Value of TS Ke Levered equity Total levered value 2004 2005 2006 2007 2008 14.20 1.40 are identical. the growth for the CFE is made using the expected CFE for the forecasting period not including the “fictitious” repurchase of equity in year N. 35 .31 4.32 2.26% The calculation for G.44% 193.49 10.46% 15.20 172.43168333 G 9.0305 287.918 0.98% − 9.05.51368333 0. TVCFE = CFE(1 + G) 11.9993 224.12 5.78 Denominator 7.05 Ke perp − G 16.46%) = = 163.29 0.20(1 + 9.27% 15.12 15.8205 314.49 17.8257 216.46% Then the calculation of the levered equity is Table A14.48 6.20 1.09 16.09 16.48 310.7686 263.00 2.20 14. Calculation of G assuming ψ=Kd Term 1 Term 2 Sum Numerator 1.00 2. The terminal value for the CFE is 163.64 126.5327 208.G= FCF(1 + g )(1 − D% perp )K e − CFE(WACC perp − g ) FCF(1 + g )(1 − D% perp ) + CFE(WACC perp − g) we have Table A13.60 2.9796 We can compare with the other tables and find that the levered values and the Ke 11.40 6.6666 268. With this G we can calculate the TV for the CFE assuming ψ = Kd.
20 11.25 FCF with TVFCF 8. can be calculated as follows TVFCF = FCF(1 + g) 14.49% − 7% Using the WACCadj from table 5.80 13.32% 14.4398 244.25 WACC perp − g 12.5133 219.TS i i 14.2427 36 .9405 176.19% ViL1 − Total levered value 188. for the FCF we have to estimate the WACC at perpetuity WACCperp. the terminal value for the FCF.80 TVFCF 288.3965 Levered equity 164. the L Vi −1 levered value of the firm and the equity.40 WACCadj = Ku . TVFCF.80(1 + 7%) = = 288. we are assuming that there is no additional investment at perpetuity.21% 14.46% 14.00 2.TKdθ = 15. Table A15. Using the data from Table A4b we calculate the levered values using the FCF and the adjusted WACC. Hence. ψ=Ku: Levered values calculated with FCF and Adjusted WACC Year 2003 2004 2005 2006 2007 2008 FCF 8.11% 14. Finite cash flows and Ku as the discount rate for the TS Now we will derive the firm and equity values using several methods and assuming finite cash flows and Ku as the discount rate for the TS. From Table 5 we have WACCperp = Ku i .2271 186.20 11.20 12.094% − 40% × 13% × 50% = 12.80 14.05 TS 1.20 12.6671 265.TS i we calculate solving the circularity.0174 206.20 1.80 303.40 2.9782 198.At this moment we are not surprised that the values match because in all the methods we have kept the same assumptions and we have used the correct formulations for each set of assumptions. In order to calculate the terminal value TV.60 2. Ku i . given our assumptions.49% For simplicity and without losing generality.80 13.9963 225.
20 12.52% 15.88% 12.5133 219.80 14.25 FCF with TVFCF 8.32% 14.80 14.4398 244. It is not strange because we have used the same assumptions and the correct formulations in each case.20 11.39% 15.3965 Levered equity 164.80 303.46% 15. 37 . Table A16.05 Kd(1T) 7.6671 265.45 WACCCCF 15. ψ=Ku: Levered values calculated with CCF and WACC for CCF Year 2003 2004 2005 2006 2007 2008 CCF 9.9963 225. we present the values calculated using it.53% E iL1 KeE% 13.094% Levered value 188.80 16.094% 15.80% 7.2427 As expected.40 12.2271 186.6671 265.9405 176. From Table 3 we know that the correct formulation for Ke with finite cash flows and Ku as the discount rate for TS is Ku i + (Ku i .2427 As we expected.Ke i E i1 D i1 and the traditional WACC is Kd i (1 − T ) iL1 + .80% 7.46% 14.80% 7.Now using the CCF and the WACCCCF we calculate the same values.80 TVFCF 288. as the conditions required using the traditional WACC formulation and the FCF.16% 12.Kd i ) D .20 12.50% 13. ψ=Ku: Levered values calculated with FCF and traditional WACC Year 2003 2004 2005 2006 2007 2008 FCF 8.19% Levered value 188.16% 1.0174 206.80 13.33% 1. Now we calculate the TV for the CFE as the TV for the FCF minus the outstanding debt and the equity value (and total levered value) using the CFE.094% 15.2271 186.36% D i1 Ke = Ku + (Ku .9405 176.094% 15.094% 15.9782 198.20 305. Again. Vi1 ViL1 E iL1  Table A17.80 13.47% 1.4398 244.58% 15.11% 14.20 11.80% 7.3965 Levered equity 164.83% Traditional WACC 14.9782 198. the levered values match.80% KdD% 0. the levered values coincide.Kd ) i i i 15.5133 219.21% 14. From table 6 we know that the WACCCCF is Ku.64% 12.96% 1.9963 225.0174 206.
ψ=Ku: Levered values with the CFE 2003 2004 2005 2006 2007 14.6671 265.0923 15.53% E iL1 Levered equity Total levered value 164. We have to realize that the APV when Ku is the discount rate for TS is identical to the present value of the CCF.8990 201.09 16.2427 188.Kd ) D i1 i i i 242.46% 17.58% 15.9405 176. TVCFE.3161 240.5133 219.3113 PV(TS at Ku) 6. Before calculating the values we have to calculate the terminal value for the CFE.40 PV(FCF at Ku) 181.8419 5. Table A19.2000 253. or simply subtract from the TVFCF the value of 38 .3010 15.9782 198.20 12.20 11.80 TS 1.9782 198.2427 2008 303.4923 15. the values match.4398 244.3965 Equity 164.39% 16. we obtain the total levered value. ψ=Ku: Levered values calculated with APV Year 2003 2004 2005 2006 2007 FCF with TVFCF 8.7701 263.0174 206.0174 206.00 2.2271 186.20 TVCFE = VTFCF − debt CFE + VTCFE Ke Ku + (Ku .52% 2008 11.49 10.8970 2.2271 186.10 10.CFE Table A18.20 1.80 13.9963 225. When we add the debt balance.5133 219. Section Six Now using the CFE we will calculate the TV for the CFE and levered equity value.60 2.0853 Total APV 188.1544 220.1184 5.9405 176.4923 15.20 14. G.3965 Again.49 17.1237 3. Now we examine the Adjusted Present value approach to check if keeping the assumptions the values match.9963 225.05 2.6671 265.40 Once again the values match because we have used consistent formulations for every method.4398 244. and to do that we need to estimate the growth rate for the CFE.
Kd) D E As the leverage for perpetuity is 50% the previous formulation reduces to Keperp = Ku + (Ku–Kd)D%/E% = 15. The last column is the sum of the terms at the left. the growth for the CFE is made using the expected CFE for the forecasting period not including the “fictitious” repurchase of equity in year N. we will derive the consistent value for G. G= FCF(1 + g )K e − DK e (WACC perpetuity − g ) − CFE(WACC perpetuity − g ) FCF(1 + g ) − D(WACC perpetuity − g ) + CFE(WACC perpetuity − g) and calculating the Ke for perpetuity as Ke perp = Ku + (Ku . using equations (19) and (29) Case a) Considering the debt outstanding at year N and that debt to obtain G.01% 39 .20(1 + 12.53557692 0.67071022 Denominator 15.01%) = = 242.6153 1.1010 Ke perp − G 17. ψ=Ku: Elements to calculate G.094% + (15.094% – 13%)50%/50% = 17.9157231 G 12. With this G we calculate the TVCFE as TVCFE = CFE(1 + G) 11. Table A20.the outstanding debt as we did above.43580228 −0.836 −2. the growth of the CFE (equation (19)).19% − 12.01% The calculation for G.7218125 −0.19% The components of equation (19) are shown in the next table in the order they appear in the equation. Although it is simpler to subtract the debt from the TVFCF. the growth for CFE Term 1 Term 2 Term 3 Sum Numerator 2.6153 13.
9963 225.49 17. all the calculated values.46% 15. Case b) Considering the level of debt to obtain the perpetual leverage D%perp In this case we have to consider an additional debt (repayment) to reach the defined perpetual leverage D%perp.From Table 3 we know that the formulation for Ke for finite cash flows and Kd as discount rate for the TS is Ku i + (Ku i .49 10.53% Levered equity 164.2427 Levered value 188. Now we have the CFE.5133 219.9405 176.20 VTCFE 242. This extra debt will be considered as equity repurchase as will be shown below in Table A23. including the calculations for the cost of capital match when we use the consistent assumptions and the proper formulations for each case. As we can see.1010 CFE + TVCFE 14. ψ=Ku: Levered values calculated with CFE and Ke Year 2003 2004 2005 2006 2007 2008 CFE 14.09 16. the values match as expected. hence we can estimate the FCF and the CCF taking into account that the level of debt at year N is D%perp × TV.9782 198.Kd i ) D i1 E iL1 .4398 244. the CFD and the TS.2000 253.2271 186.52% 15.6671 265.4923 10. But this implies to calculate the terminal value.3965 Once again.0174 206.4923 17.20 11. 40 .3010 Ke 15.58% 15. Table A21.39% 15.0923 16.
ψ=Ku: FCF and CCF derived from CFD.08 30.49 10.15 46.20 11.918 0.69 −2.000 4.00 −91.49 10.20 11.20 12.80 16.20 17. the outstanding debt in the forecasting period we apply equation (29).80 14.20 Repurchase of equity 97.49 17.40 12.000 6.80 16.69 −7.80 13.80 14.77 38.20 17. Calculation of G assuming ψ=Ku Term 1 Term 2 Sum Numerator 1.80 CCF = FCF + TS 9.49 17.6153 8.80 14.97 Total CFD −4.69 6.40 12.08 30.20 1.09 16.15 New debt 97.000 5.000 6.77 38.60 2.Table A22.09 16.20 109.000 Principal payment −7.69 −7.46 46.20 If we use the expression for G using D%perp instead of D.36090625 0.00 2.69 −3.97 CFE 14.15 46.40 FCF = CFD + CFE – TS 8.74560625 Denominator 7.17 Sum = CFD + CFE 9. CFE and TS Year 2003 2004 2005 2006 2007 2008 Debt at beginning 23. Applying eq (29) we have Table A23.46 46.74% 41 .97 Total CFE 14.15 46.20 TS 1.6153 0.97 Total debt 23.13 Interest charges 3.5333 G 8.69 0.15 144.00 −97. The terminal value for the CFE has to be calculated always with the CFE before any equity repurchase because that value is the one generated by the firm to pay to the equity holders. G= FCF(1 + g )(1 − D% perp )K e − CFE(WACC perp − g ) FCF(1 + g )(1 − D% perp ) + CFE(WACC perp − g) We consider that the extra debt (extra payment) is an amount that has to be added (subtracted) to the terminal value for the CFE.40 2.
97 10.52% 164. the growth for the CFE is made using the expected CFE for the forecasting period not including the “fictitious” repurchase of equity in year N.46% 15.3010 15.2000 253.The calculation for G. The terminal value is TVCFE = CFE(1 + G) 11.39% 15.6671 2008 11. With this example we have shown that when done properly.20 144.20(1 + 8.19% − 8.74% Then the calculation of the levered equity is Table A24. the CCF or the CFE. From the exploration of the calculated levered values we observe that the values obtained when we assume Ku as the discount rate are higher than those calculated with Kd as the discount rate.4398 244.0923 16. we can arrive to the correct levered values using the FCF.20 14.53% 219.58% 15.9405 176.4923 15.4923 17.09 16. With this G we can calculate the TV for the CFE assuming ψ = Ku.0174 206.13 Ke perp − G 17.13 97. This is not a surprise because the former does not have the (1 – T) factor in the calculation of the Ke and this makes the discount rates higher than when we 42 . When using the CFE we can derive its terminal value subtracting outstanding debt from the TV for the FCF or calculating the terminal value for the CFE either taking into account the outstanding debt at year N or taking into account the total debt as defined by the perpetual leverage.5133 188.2427 265.2271 186.49 17.3965 CFE TV CFE Repurchase of equity Total CFE Ke Levered equity Total levered value We can compare with table A15 and find that the levered values and the Ke are identical. Calculation of levered equity using D%perp and ψ=Ku 2003 2004 2005 2006 2007 14. D%perp.9782 198.9963 225.74%) = = 144.49 10.
21% Levered equity 193. 43 .33% In pointing out these differences we are not claiming that one assumption is correct and the other is incorrect.53 164.02 15.61 188. That is a debate that has not concluded.94 17.use the (1 – T) factor in the calculation of Ke. The differences between levered values are as shown in the next table. Table A25. Differences in using Kd or Ku as assumption regarding the discount rate for TS Discount rate for TS Kd Ku Difference Total levered value 216.