Valuation of Cash Flows with Constant Leverage: Further Insights

13 Pages Posted: 30 Jan 2006

See all articles by Ignacio Velez-Pareja

Ignacio Velez-Pareja

Grupo Consultor CAV Capital Advisory & Valuation

Joseph Tham

Duke University - Duke Center for International Development in the Sanford School of Public Policy; Academy of Public Administration under the President of the Republic of Kazakhstan

Date Written: May 20, 2006

Abstract

It is widely known that if the leverage is constant over time, then the cost of equity and the Weighted Average Cost of Capital (WACC) for the free cash flow, FCF, is constant over time. In other words, it is inappropriate to use a constant WACCFCF to discount the free cash flow (FCF) if the leverage changes over time and some conditions are not satisfied. However, it is common to find analysts who inconsistently use a constant WACCFCF even if the leverage is not constant and the proper conditions are not satisfied.

In this teaching note, we use a simple numerical example to illustrate how to model cash flows that are consistent with constant leverage. We verify the consistency of the example with two basic principles: conservation of cash flows and conservation of values.

The note is based on a previous one and includes the procedure to value with constant leverage when some restrictive conditions are not satisfied.

Keywords: WACC, constant leverage, cash flows

JEL Classification: D61, G31, H43

Suggested Citation

Velez-Pareja, Ignacio and Tham, Joseph, Valuation of Cash Flows with Constant Leverage: Further Insights (May 20, 2006). Available at SSRN: https://ssrn.com/abstract=879505 or http://dx.doi.org/10.2139/ssrn.879505

Ignacio Velez-Pareja (Contact Author)

Grupo Consultor CAV Capital Advisory & Valuation ( email )

Ave Miramar # 18-93 Apt 6A
Cartagena
Colombia
+573112333074 (Phone)

HOME PAGE: http://cashflow88.com/decisiones/decisiones.html

Joseph Tham

Duke University - Duke Center for International Development in the Sanford School of Public Policy ( email )

Box 90312
302, Towerview Dr, Rubenstein Hall, Room 272
Durham, NC 27708
United States
919-613-9234 (Phone)
919-681-0831 (Fax)

HOME PAGE: http://fds.duke.edu/db/Sanford/faculty/thamjx

Academy of Public Administration under the President of the Republic of Kazakhstan ( email )

Abay Street, 33a
Astana
Kazakhstan
+7 8 7172753422 (Phone)

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