Matching Methods in Valuation with Finite Cash Flows: An Almost Perfect Textbook Example

Abstract

In this note, we extend a numerical example in the textbook by Berk & DeMarzo that matches methods for only when K_TS is equal to K_D. We show that there is a generalized formulation for the return to levered equity K_E that works for any value of K_TS, the appropriate discount rate for the tax shield. We debunk the view that the CFE (Cash Flow to Equity) method is “apparently simple but practically confusing and useless.” Due diligence in professional valuation demands that we practice triangulation as Standard Operating Procedure (SOP). This formula is irrelevant for anyone who believes in the Pablo Fernandez (PF) approach to valuation because the concept of a “discount rate for the tax shield” is obviously nonsensical and almost surely absurd.

Note: Upon request, the authors would be delighted to send you an accompanying spreadsheet.

Keywords: Weighted Average Cost of Capital (WACC), Free Cash Flow (FCF), Tax Shield

JEL Classification: D61, H43, M21, M40, M46, G12, G31, G33