Valuation of Cash Flows with Constant Leverage: Further Insights
It is widely known that if the leverage is constant over time, then the cost of equity and the Weighted Average Cost of Capital (WACC) for the free cash flow, FCF, is constant over time. In other words, it is inappropriate to use a constant WACCFCF to discount the free cash flow (FCF) if the leverage changes over time and some conditions are not satisfied. However, it is common to find analysts who inconsistently use a constant WACCFCF even if the leverage is not constant and the proper conditions are not satisfied. In this teaching note, we use a simple numerical example to illustrate how to modelcash flows that are consistent with constant leverage. We verify the consistency of the example with two basic principles: conservation of cash flows and conservation of values. The note is based on a previous one and includes the procedure to value with constant leverage when some restrictive conditions are not satisfied.
Constant Leverage Modeling: A Reply to 'a Tutorial on the Mckinsey Model for Valuation of Companies'
In this note we analyze the tutorial based on the McKinsey methodology for valuing companies. We have found that the McKinsey methodology has one of the most common mistakes mentioned in Tham and Velez-Pareja (2004a and b): valuing cash flows with a constant cost of capital when the leverage is not constant. We calculate the proper firm andequity values by assuming the free cash flow, FCF calculated in the tutorial, and deriving the cash flow to equity, CFE. We develop the proper calculations of firm and equity values for constant leverage as well. For both calculations we calculate the deviations from the values calculated in the tutorial.
Principles of Cash Flow Valuation: An Integrated Market-Based Approach
Basic concepts in market-based cash flow valuation Time value of money (TVM) and introduction to cost of capital Basic review of financial statements and accounting concepts Constructing integrated pro-forma financial statements Derivation of the free cash flows Using the WACC in theory and in practice Estimating the WACC for non traded firms Beyond the planning period: calculating the terminal value Theory for cost of capital revisited How are Cash Flows Valued in Reality?