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Web3ch4 - CHAPTER FOUR Cash Accounting Accrual Accounting...

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CHAPTER FOUR Cash Accounting, Accrual Accounting, and Discounted Cash Flow Valuation Stephen H. Penman The web page for Chapter Four runs under the following headings: What this Chapter is Doing A Simple Illustration of Discounted Cash Flow Valuation Understanding Discounted Cash Flow Analysis and its Problems Back to the Valuation of a Savings Account Moving from the Savings Account to Equities Is Cash King? Beware of a Common Dictum: do Cash Flow Valuation and Accrual Accounting Valuation Always Give the Same Value? Cash Earnings: Beware What Do Analysts Forecast? Problems with the GAAP Statement of Cash Flows The U.K. Statement of Cash Flows Further Discussion of the Difference Between Cash Accounting and Accrual Accounting Readers’ Corner What this Chapter is Doing Chapter Four does four things. First, it lays out how to do discounted cash flow valuations. Second, it shows how forecasting cash flows runs into problems.
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Third, it introduces you to the cash flow statement and points out that GAAP cash flow statements do not report free cash flow cleanly. Fourth, it contrasts cash accounting and accrual accounting. This sets the stage for introducing accrual accounting models in Chapters 5 and 6. A Simple Illustration of Discounted Cash Flow Valuation To ensure that you understand the mechanics for DCF valuation, here is a simple example. Valuation always works from a pro forma. For DCF analysis, that pro forma contains forecasts of free cash flows. The following pro forma forecasts free cash flow, but also earnings and book values (that will be used in corresponding examples in Chapter 5 and in Chapter 6 of the text). The task is to value the equity at the end of 2000. To keep it simple, the firm has no net debt, so the value of the equity equals the value of the firm (the present value of forecasted free cash flows). Forecasts for a firm with expected earnings growth of three percent per year (in dollars). Required return is 10% per year. Forecast Year __________________________________________ 2000 2001 2002 2003 2004 2005 You see here that free cash flow is forecasted to grow at 3% per year. If this rate is forecasted to continue, the value of the firm (and the value of the equity with no debt) is: 6105 . 1 03 . 1 10 . 1 03 . 1 53 . 10 6105 . 1 53 . 10 4641 . 1 23 . 10 331 . 1 93 . 9 21 . 1 64 . 9 10 . 1 36 . 9 0 - × + + + + + = E V = 133.71 Remember that a continuing value at a point in time (2005) is always calculated as the free cash flow for the following year (2006) capitalized at the required rate of return, adjusted for growth. So the continuing value here is based on 2005 free cash flow Earnings 12.00 12.36 12.73 13.11 13.51 13.91 Free cash flow 9.36 9.64 9.93 10.23 10.53 Book value 100.00 103.00 106.09 109.27 112.55 115.93
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growing one period (in 2006); this amount is then capitalized at the required return adjusted for the growth rate.
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As free cash flow is forecasted to grow at 3% per year from 2002 onwards, the valuation can be made using a shorter forecast horizon: 03 . 1 10 . 1 36 . 9 0 - = E V = 133.71 Compare this valuation with those (for the same example) using P/B and P/E methods on the web pages for Chapters 5 and 6.
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