BAB 6

The Economic Balance

Sheet and on Overview
of Cash Flow Based
Valuation Models
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ECONOMIC BALANCE SHEET
DEFINITION
The economic balance
sheet is a statement
showing the estimated fair
values of all items that
represent an economic
asset or liability for the firm,
along with the implied value
of the firm’s equity.
EQUITY TRUE VALUE
The true value of the
company's equity is the
total fair value of all items
that are economically
assets minus the fair value
of all items that are
economically liabilities of
the company.
 ECONOMIC BALANCE SHEET
VS
GAAP BALANCE SHEET
(1) Economic balance sheet items are classified in a different way
than under GAAP

(2) The economic balance sheet includes all items that are
conceptually assets or liabilities; no recognition test as in GAAP

(3) The economic balance sheet uses fair values for all items.

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1. CORE OPERATIONS (CORE)

ECONOMIC 2. NON-OPERATING ASSETS
BALANCE SHEET (NONOP)
3. DEBT CLAIMS (DEBT)
ITEMS ARE 4. OTHER CAPITAL CLAIMS
(OCAP)
CLASSIFIED  5. COMMON EQUITY CLAIMS
(COMEQUITY)
 1. CORE OPERATION (CORE)
o Core operations are the assets and liabilities central to the basic
business, which could not be easily separated from each other
without affecting the cash-generating ability of the entity.
o If core operations are separated from the company, it will cause big
problems in the company's ability to generate cash flow.
o Core operations are assessed based on aggregate values
determined using a particular model.
o Core operations are not assessed individually by component
 2. NON-OPERATING ASSETS
o are assets and liabilities that are not an integral part of the
company’s CORE operations
o In general, the company will not face big problems if the non-
operating net assets are separated from the company.
o Examples of NONOP are marketable securities, investments in other
companies, joint ventures, cash in excess of the amount required to
operate business, land that is not used for operations, and others.
o Non-operating net assets or liability by appraisal, by doing separate
cash flow valuation, or by observing market value.
 3. DEBT CLAIMS (DEBT)
o Debit claims are the claims against the firm held by those who have
loaned it money.

o Debt claims include : long-term debt, capitalized leases, short-term

debt, current maturities of long-term debt, and notes payable.
 4. OTHER CAPITAL CLAIMS
o OCAP include all claims on the firm’s assets that are not common
equity and are not included in core operation, non-operating assets,
or debt claims.

o Example : preferred stock, employee stock options, warrants, and

minority interest.
 5. COMMON EQUITY
o Common equity claim is the residual claim belonging to the
common stakeholder
 ECONOMIC ASSET AND
ECONOMIC LIABILITIES
o In the economic account, the concept of recognizing assets and liabilities is
based on an economic concept.
o All items that will affect the value of the company in the future that investors
are willing to pay are items that can be recognized in the economic balance
sheet.
o Contingent assets, contingent liabilities, and stock options are examples of
items that cannot be recognized in the accounting balance but are
recognized in the economic balance sheet.
o Experts owned by the company also cannot be recognized as company
assets according to accounting, because accounting experts are not
controlled by the company.
 ECONOMIC BALANCE SHEET
USES FAIR VALUE
o All items in the economic balance sheet are valued at their fair value.
o Fair value is the value of assets and liabilities based on their economic value.
The accounting balance uses a variety of valuations for the presentation of
assets and liabilities: historical value, replacement value, net selling value, or
the lower of historical value and fair value.
o In the economic balance sheet, the core operations component is valued
based on its estimated fair value, not the sum of the book values of each
component of assets and liabilities.
o In general, there is a large difference between the fair value of core
operations and their book value.
Cash Flows and the Firm

Debt Claims
Core
$7,168,000
Operations
Debt Service
$7,800,000 Free Cash Flow

Other Capital Other Capital

Firm Cash Flow Claims
$371,941,000
Nonoperating Cash Flow
Dividends
Nonoperating
Common Equity
Net Assets
Claims
$117,175,000 $7,538,066,000
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The Valuation Model

▫ Dividend discount model

CORE + NONOP = DEBT + OCAP + COMEQUITY
COMEQUITY = CORE + NONOP – DEBT – OCAP
▫ Flows to equity model
▫ Free cash flow model
▫ Adjusted present value model
▫ Residual income model
 Dividend Discount Model

Core Debt Claims

Operations
$7,168,000
$7,800,000 Debt Service
Free Cash Flow

Firm Other Capital Other Capital

Cash Flow Claims
Nonoperating Cash Flow $371,941,000
Dividends
Nonoperating
Net Assets
Common Equity
$117,175,000 Claims
$7,538,066,000
COMEQUITY = PV (DIVIDENDS)
 Flows to Equity Model
Core Debt Claims
Operations $7,168,000
$7,800,000 Debt Service
Free Cash Flow

Firm Other Capital Other Capital

Cash Flow Cliams
Nonoperating Cash Flow $371,941,000
Dividends
Nonoperating
Net Assets
Common Equity
$117,175,000 Claims
$7,538,066,000

COMEQUITY = PV [ FCF + NONOP CASH FLOW - DEBT SERVICE – OCAP CASH FLOW]
 Free Cash Flow Model
Core Debt Claims
Operations
$7,168,000
$7,800,000 Debt Service
Free Cash Flow
Other Capital
Firm Other Capital Claims
Cash Flow
$371,941,000
Nonoperating Cash Flow
Dividends
Nonoperating
Net Assets
Common Equity
$117,175,000 Claims
$7,538,066,000

COMEQUITY = PV (FCF) + NONOP – DEBT - OCAP

 Adjusted Present Value Model

Core Debt Claims

Operations $7,168,000
$7,800,000 Debt Service
Free Cash Flow
Other Capital
Firm Other Capital Claims
Cash Flow
$371,941,000
Nonoperating Cash Flow
Dividends
Nonoperating
Net Assets Common Equity
$117,175,000 Claims
$7,538,066,000

COMEQUITY = PV (FCF at unlevered cost of equity) + VALUE OF LEVERAGE + NONOP

– DEBT - OCAP
 Residual Income Model
Core Debt Claims
Operations
$7,168,000
$7,800,000 Debt Service
Free Cash Flow

Firm Other Capital Other Capital

Cash Flow Claims
Nonoperating Cash Flow $371,941,000
Dividends
Nonoperating
Net Assets
Common Equity
$117,175,000 Claims
$7,538,066,000

COMEQUITY = BV ( CORE ) + PV ( RI from core ) + NONOP – DEBT -

OCAP
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