1. Abstract
§ The paper assist the user of DCF methods by clearly setting forth the relationship of free-cash-flow (FCF) and economic value added (EVATM) concept to each other and to the more traditional applications of DCF thinking such as NPV
§ The equivalence between EVA and NPV, approaches:
i. Links the problems of security valuation, enterprise valuation, and investment project selection
ii. Relates to more directly use of standard financial accounting information
§ FCF approach → focuses on the periodic total cash flows obtained by deducting total net investment and adding net debt issuance to net operating cash flow
§ EVA(TM) approach → requires defining the periodic total investment in the firm
§ FCF and EVA(TM) are equivalent to NPV
2. Introduction
§ The use of DCF method for investment decision making and valuation is well entrenched in finance theory and practices
§ Modern literature has broadened application of DCF techniques → capital budgeting and security valuation problems
§ Free cash flow → security valuation
§ Economic value added → managerial performance evaluation
3. Cash Flow
a. The cash budget identity
i. Consider the single period cash budget identity
ii. The components are operating revenues and cost, net security issuance, interest payments, dividend payments, taxes paid, and net investment.
iii. Investment maybe divided into working capital and long-term investment
iv. In practice, use of accounting information for economic analysis requires a number of adjustments to bring the accounting numbers into conformity with economic reality
v. Sources = Uses
Rt + ∆Bt = Ot + Intt + Divt + Taxest + ∆It + ∆WCt
b. Dividends
i. Divt = (Net profit after tax + depreciation) – total net investment + net debt issuance
§ The paper assist the user of DCF methods by clearly setting forth the relationship of free-cash-flow (FCF) and economic value added (EVATM) concept to each other and to the more traditional applications of DCF thinking such as NPV
§ The equivalence between EVA and NPV, approaches:
i. Links the problems of security valuation, enterprise valuation, and investment project selection
ii. Relates to more directly use of standard financial accounting information
§ FCF approach → focuses on the periodic total cash flows obtained by deducting total net investment and adding net debt issuance to net operating cash flow
§ EVA(TM) approach → requires defining the periodic total investment in the firm
§ FCF and EVA(TM) are equivalent to NPV
2. Introduction
§ The use of DCF method for investment decision making and valuation is well entrenched in finance theory and practices
§ Modern literature has broadened application of DCF techniques → capital budgeting and security valuation problems
§ Free cash flow → security valuation
§ Economic value added → managerial performance evaluation
3. Cash Flow
a. The cash budget identity
i. Consider the single period cash budget identity
ii. The components are operating revenues and cost, net security issuance, interest payments, dividend payments, taxes paid, and net investment.
iii. Investment maybe divided into working capital and long-term investment
iv. In practice, use of accounting information for economic analysis requires a number of adjustments to bring the accounting numbers into conformity with economic reality
v. Sources = Uses
Rt + ∆Bt = Ot + Intt + Divt + Taxest + ∆It + ∆WCt
b. Dividends
i. Divt = (Net profit after tax + depreciation) – total net investment + net debt issuance
c. Divisions of cash flow among investors
i. Cash flow to equity (CFE is equivalent to our expression for dividend
ii. Proponents of the FCFE method emphasize that FCFE is dividends that could be paid to shareholders
iii. The difference between FCFE and dividends paid in given year maybe characterized as investment in “excess marketable securities” and its omission from consideration is moot so long as such investments have zero NPV
iv. Cash flow to debt holders in period t, CFDt:
CFDt = Intt - ∆Bt = interest paymentst – net debt issuance
d. Taxes
i. Consider the total-taxes-paid component of cash flow to equity
ii. It is being equal to the tax on operating income before interest – the tax-shield benefits provided by interest payments
iii. Taxest = tax with no debt financing – interst-tax-shield benefits
e. Free cash flow to the firm
i. Free cash flow to the firm → cash flow to equity + cash flow to debt holders – interest-tax-shield benefits from the cash flow to debt holders
ii. We can express that
© CFFt = after tax operating profit from equivalent unlevered firm + depreciation – totaol net investment
4. Valuation
i. Three basic business contexts:
© Project valuation (capital budgeting)
© Security valuation
© Firm valuation
ii. Purpose → demonstrate the conceptual consistency in valuation methodology among the various computational techniques employed in the three valuation contexts
a. Equity valuation by the dividend discount approach
i.
b. Equity valuation by the free-cash-flow-to-equity approach
i.
c. Debt valuation
i.
d. Total firm valuation
i. Total firm value:
ii. To express free cash flow to the firm, firm value can be described in terms of NOPAT, depreciation, and total net investment
e. Project valuation
i.
f. Economic profit (EP) and economic value added (EVATM)
i. The concept of EP boils down to a simple restatement of total firm valuation that “reallocates” investment expenditures from the periods in which they are made to periods over which their resulting benefits occur.
ii. In the EVA(TM) approach to EP →the reallocation assigns to each period an “EVA(TM) depreciation” component representing the “usage” of a portion of the cost of the firm, plus a “capital charge” representing the opportunity cost of the remaining net investment in the firm
iii. The computation of EP:
EPt = (NOPATt + difference between tax depreciation and EVA(TM) depreciation – capital charges on EVA(TM) operating assets / economic profitt
5. Measurement Issues
§ Another important use of valuation concepts requiring use of accounting information is determination of managerial compensation
§ Spirit of managerial compensation arrangement → to reward manager to increase shareholders value → measurement of changes in firm value is critical
§ With the free cash flow model, income must be adjusted for the fact that GAAP involve reliance on both the realization and matching principles
a. Derivation of operating cash flow from accounting profit
i. The dividend discount and free cash flow to equity models adjust accounting profits by starting with NPAT, then adding depreciation and net debt issuance, and subtracting total net investment
b. Derivation of economic profit from accounting profit
i. It is not only concerned with reconciliation of accounting profit and cash flow, but also focuses on issues defining the capital investment in the firm
6. Conclusions
a. Free cash flow, economic value added, and net present value approaches to valuation and decision-making are equivalent
b. Linkage among the problems of security valuation, enterprise valuation, and investment project selection, and by doing so in a manner that relates directly to the use of standard financial accounting information
c. Net operating profit after tax (NOPAT) → adding after tax interest payments to net profit after taxes
d. FCF approach → focuses in periodic total cash flow obtained by deducting total net investment and adding net debt issuance to net operating cash flow
e. EVA(TM) approach → requires defining the periodic total investment in the firm
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