Firm Valuation with Cash-Flow@Risk

Abstract:     
We propose in this article an alternative approach to the Discounted Cash-Flow model based on the concept of economic capital developed by Merton and Perold (1993). We define what we call cash-flow@risk that consists in stripping future cash-flows, each cut into two parts, a low risk part (supporting debt funding within rating objective) and a high risk part (to be funded with equity), and discounted at the corresponding appropriate discount rates of debt and equity. Compared with the DCF approach, our model presents several advantages. Firstly, valuation has to depend much on risk and on the cost of risk. Having set a target of risk and properly measured the cost of risk will lead to a specific and better valuation. Secondly, we consider that the firm leverage is a key issue and has to be taken into account in the valuation process. Lastly, we show that the firm can reduce its risk and its economic capital need, holding two or more business lines presenting a correlation coefficient lower than one.

Number of Pages in PDF File: 29

Keywords: Economic Capital, Financial Flexibility, Firm Valuation, DCF

JEL Classification: G01, G11, G30, G31, G32

working papers series