A Practical Guide for Consistency in Valuation: Cash Flows, Terminal Value and Cost of Capital
45 Pages Posted: 9 Dec 2003
Date Written: May 29, 2005
Practitioners and teachers very easily break some consistency rules when doing or teaching valuation of assets. In this short and simple note we present a practical guide to call the attention upon the most frequent broken consistency rules. They have to do firstly with the consistency in the matching of the cash flows, this is, the free cash flow (FCF), the cash flow to debt (CFD), the cash flow to equity (CFE) and the tax savings or tax shield (TS). Secondly, they have to do with the proper expression for the cost of unlevered equity with finite cash flows and perpetuities. Thirdly, they have to do with the consistency between the terminal value and growth for the FCF and the terminal value and growth for the CFE, when there is a jump in the CFE due to the adjustment of debt to comply with the leverage at perpetuity. And finally, the proper determination of the cost of capital either departing from the cost of unlevered equity (Ku) or the cost of levered equity (Ke). In the Appendixes we show some algebraic derivations and an example.
Keywords: Cash flows, free cash flow, cash flow to equity, valuation, levered value, levered equity value, terminal value, cost of levered equity, cost of unlevered equity
JEL Classification: M41, G12, G31
Suggested Citation: Suggested Citation