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ACCT820 Chapter 12 Valuation Cash Flow Based Approaches[1]

ACCT820 Chapter 12 Valuation Cash Flow Based Approaches[1]...

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Rationale for Cash-Flow-Based Valuation Cash flow based valuation & dividends based valuation can be considered 2 sides to the same coin: the analyst can value the firm based on the CFs into the firm that will be used to pay dividends, or, equivalently, value the firm using CFs the firm pays out in dividends to common shareholders o In the CFs approach, we focus on the cash that flows into the firm; in the dividends approach we focus on the cash that flows out of the firm o Instead of focusing on wealth distribution through dividends, the CF based approach focuses on CFs generated by the firm that create dividend paying capacity o In any given period, the amount of CF into the firm & the amount of dividends paid out of the firm will likely differ; the equivalence of these 2 valuation approaches arises b/c over the lifetime of the firm the CFs into & out of the firm will be equivalent The CF based valuation approach measures & values the CFs that are “free” to be distributed to shareholders; that is, FCFs are the CFs each period that are available for distribution to shareholders, unencumbered by necessary reinvestments in op assets or required payments to debt holders o FCFs can be used instead of dividends as the value relevant measures of expected future payoffs to the investor in the numerator of the general value model o Both approaches, if implemented w/consistent assumptions, will lead to identical estimates of value The rational for using expected FCFs in valuation is twofold & is essentially the same rationale for using dividends, as follows: o Cash is the ultimate source of value – a resource has value b/c of its ability to provide future CFs; the FCFs approach measures value based on the CFs that the firm generates that can be distributed to investors o Cash is a measurable common denominator for comparing the future benefits of alternative investment opportunities Free-Cash-Flows-Based Valuation Concepts Key concepts in FCFs based valuation methods are the same underlying concepts in dividends-based methods: risk, discount rates, & the cost of capital; CFs to the investor vs. CFs to the firm; nominal vs. real CFs; pretax vs. after tax CFs; the forecast horizon; & computation of continuing value CFs to the Investor vs. CFs to the firm: o The analyst can use expectations of the dividends to be paid to the investor or the FCFs to be generated by the firm as equivalent approaches to measure the value relevant expected payoffs to shareholders o CFs paid to the investor via dividends & FCFs available for common equity shareholders will differ to the extent that the firm reinvests a portion (or all) of CFs generated However, if the firm generates a rate of return on reinvested FCF equal to the discount rate used by the investor (cost of equity capital), either set of payoffs (dividends or FCFs) will yield the same valuation of a firm’s shares Nominal vs. Real CFs:
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o Changes in general price levels (inflation/deflation) cause the purchasing power of
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