How to Avoid Mistakes in Valuation - Comment to 'Consistency in Valuation: A Practical Guide' by Velez-Pareja and Burbano-Perez and Some Pedagogical Notes on Valuation and Costs of Capital
12 Pages Posted: 10 Mar 2010
Date Written: December 21, 2009
The paper discusses common mistakes made by financial profession when valuating cash flows by applying inconsistent weighted average discount rates to cash flows to equity, to unlevered firm, to levered firm or other complex cash flows not regarding their type (constant or growing perpetuities, or finite). The author supports the suggestions of Velez-Pareja and Burbano-Perez and believes that the Table reviewing specific formulas for every type of cash flows should be included in modern textbooks and practical guidelines concerning valuation. The preferred method for valuation is Discounting-by-Components (D-by-C) approach, which allows avoid circularity and reduces the probability of errors for above-mentioned inconsistencies.
The paper suggests convenient generalized approach of deriving appropriate discount rates of any complexity using simple Weighted Average Cost of Capital Calculation Table based on the structure of cash flow evaluated. Such a Table allows quickly construct the needed cost of capital rate including Cost of Equity, WACC for Capital Cash Flow or WACC for Cash Flow to Firm etc. of available inputs. Suggested approach provides possibility to easily modify cost of capital formulas and removes the need to memorize complex formulas. For instance one can include in the weighted average cost of capital various interest rates on debt taking into account its subordinated structure, include preferred shares and so on. It is also shown how to artificially incorporate in the cost of capital not only the tax benefits on interest on debt, but also costs of financial distress and other expected or potential cash flows taking place at any moment in future.
Keywords: Valuation, Cash Flow, WACC, Cost of Equity, Financial Leverage, Cost of Levered Equity, Cost of Unlevered Equity
JEL Classification: M21, M40, M46, M41, G12, G31, J33
Suggested Citation: Suggested Citation