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Chapter 11

Chapter 11. Valuation: Cash Flow. Valuation: Cash basis better than Accrual?. Accrual earnings cannot be spent Debatable, legitimate accounting Earnings management. Cash Flows: Three Components. Periodic Cash Flow Terminal Value Discount Rate. Periodic Flows.

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Chapter 11

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  1. Chapter 11 Valuation: Cash Flow

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

  3. Cash Flows: Three Components • Periodic Cash Flow • Terminal Value • Discount Rate

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

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

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

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

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

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

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

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

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

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

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

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