Economic Balance Sheet and Firm Cash Flows

1
Economic Balance Sheet and Firm Cash Flows
Debt Claims
Core Operations
Debt Service
Free Cash Flow
Other Capital Claims
Firm
Other Capital
Cash Flows
Nonoperating Cash Flow
Dividends
Nonoperating Net Assets
Common Equity Claims
2
Theoretically

• PV CF from operating net assets
• PV CF from non-operating net assets
• - PV CF to debtholders
• - PV CF to other capital providers
• COMEQ (PV of the CF to equityholders)

3
The Valuation Models
Dividend Discount
Flows to Equity
Residual Income
Free Cash Flow
Adjusted Present Value
4
The Valuation Models Continued

• Given identical assumptions, all five models
  result in the same value for common equity

5
The Valuation Models Continued

• The differences among the models are
• How the computation is done
• What factors about the firm are highlighted in
  the process

6
The Valuation Models Continued

• 1. The Dividend Discount Model
• Forecasts and discounts dividends

COMEQUITY PV(DIVIDENDS)
COMEQUITY means Value of Common Equity
PV means Present Value
7
Dividend Discount Model
Debt Claims
Core Operations
Debt Service
Free Cash Flow
Other Capital Claims
Firm
Other Capital
Cash Flows
Nonoperating Cash Flow
Dividends
Nonoperating Net Assets
Common Equity Claims
8
The Valuation Models Continued

• 2. The Flows to Equity Model
• Forecasts and discounts all cash
  flows other than those to the common
  equity holders

9
The Valuation Models Continued

• The Flows to Equity Model

COMEQUITY PV(FCF NONOPERATING CASH FLOW
? DEBT
SERVICE
? OTHER CAPITAL CASH FLOW)
FCF means Free Cash Flow
10
Flows to Equity Model
Debt Claims
Core Operations
-
Free Cash Flow (FCF)
Debt Service

-
Other Capital
Firm
Other Capital Claims
Cash Flows
Nonoperating Cash Flow
Dividends
Nonoperating Net Assets

Common Equity Claims
11
The Valuation Models Continued

• 3. The Free Cash Flow Model
• Forecasts free cash flows
• Discounts them at the weighted average cost of
  capital

12
The Valuation Models Continued

• The Free Cash Flow Model

COMEQUITY PV(FCF) NONOP ? DEBT ? OCAP
NONOP means Nonoperating Assets
OCAP means Other Capital
13
Free Cash Flow Model
Debt Claims
-
Core Operations
Free Cash Flow (FCF)
Debt Service

Other Capital
Firm
Other Capital Claims
-
Cash Flows
Nonoperating Cash Flow
Dividends
Nonoperating Net Assets

Common Equity Claims
14
The Valuation Models Continued

• 4. The Adjusted Present Value Model
• Discounts the free cash flow at the hypothetical
  discount rate the firm would face if it were
  unlevered
• Adjusts the value for the fact it is levered

15
The Valuation Models Continued

• The Adjusted Present Value Model

COMEQUITY PV(FCF at unlevered cost of equity)
VALUE OF LEVERAGE NONOP ? DEBT ?
OCAP
16
Adjusted Present Value Model
Debt Claims
-
Core Operations
Free Cash Flow (FCF)
Debt Service

Other Capital
Firm
Other Capital Claims
-
Cash Flows
Nonoperating Cash Flow
Dividends
Nonoperating Net Assets

Common Equity Claims
17
The Valuation Models Continued

• 5. The Residual Income Model
• Restates free cash flow in terms of book value
  and residual income then
  Discounts the residual
  income and adds it to book value

18
The Valuation Models Continued

• The Residual Income Model

COMEQUITY BV(CORE)
PV(RI from CORE)
NONOP ? DEBT ? OCAP
BV means Book Value
RI means Residual Income
19
Residual Income Model
Debt Claims
-
Core Operations
Free Cash Flow (FCF)
Debt Service

Other Capital
Firm
Other Capital Claims
-
Cash Flows
Nonoperating Cash Flow
Dividends
Nonoperating Net Assets

Common Equity Claims
20
The Valuation Models Continued

• Keep in mind
• Every asset and every liability from the economic
  balance sheet must appear in the valuation
  exactly once