WHICH COST OF DEBT SHOULD BE USED IN FORECASTING CASH FLOWS?

ABSTRACTFrequently, analysts and teachers use the capitalized rate of interest for the cost of debt when forecasting and discounting cash flows. Others estimate the interest payments when forecasting annual financial statements or cash flows based on the average of debt calculated with the beginning and ending balance. Others use the end of year convention that calculates the yearly interest multiplying the beginning balance times its contractual cost. The use of one or other methods is critical for the definition of the tax savings. These approaches are illustrated with examples and the differences in using them. A simple proposal to solve the problem is presented.Cost of debt, forecasting financial statements, seasonality.

Cash Flow Valuation in an Inflationary World. The Case of World Bank for Regulated Firms

We show that project evaluation should be based on free cash flows at nominal prices. We present a case where the results from the constant price method are biased upwards and there is a risk to accept bad projects. It is a widespread practice to evaluate projects at constant prices. With an example presented in the training on economic regulation of public utilities developed by the World Bank Institute we asses that methodology. We show an overvaluation of 21% when compared with the current prices methodology and using a correct Weighted Average Cost of Capital, WACC.World Bank; regulatory policy for infrastructure; developing countries; project evaluation; project appraisal; firm valuation; cost of capital; cash flows; free cash flow; capital cash flow

POTENTIAL DIVIDENDS AND ACTUAL CASH FLOWS IN EQUITY VALUATION. A CRITICAL ANALYSIS

Practitioners and most academics in valuation include changes in liquid assets (potential dividends) in the cash flows. This widespread and wrong practice is inconsistent with basic finance theory. We present economic, theoretical, and empirical arguments to support the thesis. Economic arguments underline that only flows of cash should be considered for valuation; theoretical arguments show how potential dividends lead to contradiction and to arbitrage losses. Empirical arguments, from recent studies, suggest that investors discount potential dividends with high discount rates, which means thatchanges in liquid assets are not value drivers. Hence, when valuing cash flows, we should consider only actual payments.Cash flow to equity, potential dividends, equity value.

CONSTANT LEVERAGE AND CONSTANT COST OF CAPITAL: A COMMON KNOWLEDGE HALF-TRUTH

A typical approach for valuing finite cash flows is to assume that leverage is constant (usually as target leverage) and the cost of equity, Ke and the Weighted Average Cost of Capital, WACC are also assumed to be constant. For cash flows in perpetuity, and with the cost of debt, Kd as the discount rate for the tax shield, it is indeed the case that the Ke and WACC applied to the FCF are constant if the leverage is constant. However this does not hold true for finite cash flows. In this document we show that for finite cash flows, Ke and hence WACC depend on the discount rate that is used to value the tax shield, TS and as expected, Ke and WACC are not constant with Kd as the discount rate for the tax shield, even if the leverage is constant. We illustrate this situation with a simple example. We analyze five methods: DCF using APV, FCF and traditional and general formulation for WACC, present value of CFE plus debt and Capital Cash Flow, CCF.WACC, constant cost of capital, constant leverage, cash flows

Market value calculation and the solution of circularity between value and the weighted average cost of capital WACC

Most finance textbooks present the Weighted Average Cost of Capital (WACC) calculation as: WACC = Kd×(1-T)×D% + Ke×E%, where Kd is the cost of debt before taxes, T is the tax rate, D% is the percentage of debt on total value, Ke is the cost of equity and E% is the percentage of equity on total value. All of them precise (but not with enough emphasis) that the values to calculate D% y E% are market values. Although they devote special space and thought to calculate Kd and Ke, little effort is made to the correct calculation of market values. This means that there are several points that are not sufficiently dealt with: Market values, location in time, occurrence of tax payments, WACC changes in time and the circularity in calculating WACC. The purpose of this note is to clear up these ideas, solve the circularity problem and emphasize in some ideas that usually are looked over. Also, some suggestions are presented on how to calculate, or estimate, the equity cost of capital. © 2009 Mackenzie Presbyterian University. All rights reserved

Conversación virtual con Thomas L. Saaty.

Cuando estudiaba Ingeniería Industrial en la Universidad de los Andes tuve la oportunidad de estudiar alguno de los libros sobre investigación operacional del profesor Thomas L. Saaty. Muchos años después me volví a topar con él trabajando el tema financiero y encontré una referencia a algo que había desarrollado el mismo pro- fesor Saaty y que se llamaba el “proceso de jerarquía analítica” (The Analytic Hierarchy Process (AHP)). El año pasado, por uno de esos amigos que se hacen en la red cuando se trabajan los temas de interés académico, obtuve su dirección electrónica y me decidí a escribirle con cierto temor reverencial. Mi sorpresa fue enorme al descubrir a un ser excepcional, modesto y de un gran cora- zón. No nos conocemos en persona, pero sentí una fuerte empatía con Tom desde su primera respuesta

Valoración de flujos de caja en inflación. El caso de la regulación en el Banco Mundial

We show that project evaluation should be based on free cash flows at nominal prices. We present a case where the results from the constant price method are biased upwards and there is a risk to accept bad projects. It is a widespread practice to evaluate projects at constant prices. With an example presented in the training on economic regulation of public utilities developed by the World Bank Institute we asses that methodology. We show an overvaluation of 21% when compared with the current prices methodology and using a correct Weighted Average Cost of Capital, WACC

Valoración de flujos de caja en inflación. El caso de la regulación en el Banco Mundial

We show that project evaluation should be based on free cash flows at nominal prices. We present a case where the results from the constant price method are biased upwards and there is a risk to accept bad projects. It is a widespread practice to evaluate projects at constant prices. With an example presented in the training on economic regulation of public utilities developed by the World Bank Institute we asses that methodology. We show an overvaluation of 21% when compared with the current prices methodology and using a correct Weighted Average Cost of Capital, WACC

El costo promedio ponderado de capital (wacc) para los cálculos de valuación de empresas: una respuesta

Trabajo de investigaciónLlano-Ferro (2009) propone una solución para evitar “errores significativos” cuando el Costo Promedio Ponderado de Capital (WACC) “obtenido por la fórmula general conduce a errores significativos en el valor presente neto de los cálculos de la empresa, particularmente en aquellas que se aplican a perpetuo flujo de efectivo serie”. En este trabajo se muestra que no hay “errores significativos”, pero sí un mal uso de la fórmula y el cálculo incorrecto de los valores.El Costo Promedio Ponderado de Capital (WACC) se utiliza en la financiación de varias aplicaciones, incluyendo el análisis del presupuesto de capital, los cálculos de EVA®, y la valoración de empresas. WACC obtenido por la fórmula general conduce a errores significativos en el valor presente neto de los cálculos de la firma, particularmente en las que se aplican series perpetuas de flujo de caja. El presente documento identifica el problema, y ofrece alternativas, y las fórmulas precisas para obtener el WACC para el cálculo de valuación de empresa

De vuelta a lo básico: El costo de capital depende de los flujos de caja libre

La mayoría de los textos de finanzas corporativas y los analistas presentan el cálculo del Costo Promedio Ponderado de Capital CPPC -también conocido como WACC- como independiente del Flujo de caja libre. Es una práctica común que los analistas calculen un CPPC a priori y lo usen independientemente del valor de la firma -esto es, del FCL-. En esta nota se muestra que el FCL afecta el CPPC y que esta interrelación crea una circularidad, pero además mostramos cómo se puede resolver de una manera sencilla. Hay dos apéndices: uno que explica la circularidad y otro con la derivación de la fórmula del costo del patrimonio -patrimonio-