Consistent Value Estimates from the Discounted Cash Flow (DCF) and Residual Income (Ri) Models in M & M Worlds Without and with Taxes
Fulbright Economics Teaching Program (FETP)
34 Pages Posted: 29 Nov 2000
Date Written: October 2000
Recently, Lundholm and O'Keefe (2000) identified the estimation of the WACC as an important reason for the discrepancy between the value estimates obtained from the Discounted Cash Flow (DCF) and Residual Income (RI) models. In this paper, I discuss how we can obtain consistent value estimates from the two models in M & M worlds without and with taxes.
It is common to assume that the return to unlevered equity is constant. Additionally, in practice, one assumes that the return to levered equity is constant although the debt-equity ratio is changing. In M & M worlds without and with taxes, it would be inconsistent to assume that the returns to unlevered and levered equity are constant and the debt-equity ratio is changing.
Keywords: Cost of capital, weighted average cost of capital (WACC), cash flow to equity, residual income model, discounted cash flow model, valuation, return to equity
JEL Classification: D61, H43, G31
Suggested Citation: Suggested Citation