A Tutorial on the Discounted Cash Flow Model for Valuation of Companies

All steps of the discounted cash flow model are outlined. Essential steps are: calculation of free cash flow, forecasting of future accounting data (income statements and balance sheets), and discounting of free cash flow. There is particular emphasis on forecasting those balance sheet items which relate to Property, Plant, and Equipment. There is an exemplifying valuation included (of a company called McKay), as an illustration. A number of other valuation models (abnormal earnings, adjusted present value, economic value added, and discounted dividends) are also discussed. Earlier versions of this working paper were entitled "A Tutorial on the McKinsey Model for Valuation of Companies".Valuation; free cash flow; discounting; accounting data

The Abnormal Earnings Growth Model: Applicability and Applications

We investigate a disaggregated version of the abnormal earnings growth (AEG) model of Ohlson and Juettner-Nauroth (2005). The value of the firm then becomes discounted free cash flows minus initial debt. Discounted free cash flows are equal to capitalized operating earnings from the initial stock of operating assets plus the present value of an infinite sequence of growth projects, where each growth project is valued by discounted economic value added. Sufficient conditions for the present value of the free cash flows to be equal to the sum of these two components are investigated. The Gordon growth formula is found to be one special case. Another case concerns lumpy growth projects with depreciation according to the annuity method. We then allow for three different interest rates, the required rate of return on equity under all-equity financing, the borrowing rate, and the required rate of return on equity under partial debt financing (the latter given by MM's Proposition 2). In the model of Ohlson and Juettner-Nauroth, these rates are the same. A firm-level model is developed that focuses on operating earnings and free cash flows with discounting at the required rate of return under all-equity financing. An equity-level model is then developed that focuses on bottom-line earnings and dividends with discounting at the required rate of return under partial debt financing. Relationships between the two models are explored. Dividend policy irrelevance holds only in a limited sense for the equity-level model.Financial analysis; abnormal earnings growth model; dividend policy; discounted dividends; discounted free cash flows; capitalized earnings; discounted economic value added

Currency Option Pricing in Credible Target Zones

This paper develops a model for valuing options on a currency which is maintained within a band. The starting point of our model is the well known Krugman model for exchange-rate behavior within a target zone. Results from model runs provide insight into evidence reported by other authors of mispricing of currency options by extensions of the Black-Scholes model.

Realignment Risk and Currency Option Pricing in Target Zones

This paper extends the Krugman target zone model by including a realignment mechanism. Various properties of that realignment mechanism are discussed. The movement of the exchange rate is governed both by a Wiener process on fundamental and by a Poisson jump process with endogenous realignment size. The realignment mechanism is such that (except in cases where a speculative attack occurs) no jump in fundamental is needed to accompany the jump in the exchange rate. A risk neutral valuation of currency options is constructed. Some properties of option values under realignment risk are illustrated by numerical results.

Approximate Firm Valuation with Operating Leases

Operating leases are quite important in some industries. There are two possible errors that should be avoided when valuing a company with operating leases. First, one should not neglect the implied lease debt. Such neglect distorts the calculation of free cash flow, required rate of return on the equity under partial debt financing, WACC, and residual equity value in the discounted cash flow model. Second, lease expense and implied lease debt should not be forecasted as constant, historical fractions of sales revenue in the (non-steady-state) explicit forecast period. This paper outlines an approximate procedure for handling operating leases in the discounted cash flow model. This procedure avoids the two possible errors that were mentioned.