《An_Introduction_to_Cash_Flow_Valuation_Methods》.pdf

Harvard Business School 9-295-155 Rev. October 16, 1995 An Introduction to Cash Flow Valuation Methods 1. Introduction This note provides an introduction to three cash flow valuation methods. The three methods differ in their measure of cash flows and the discount rate applied to those cash flows. The names for the three methods correspond to the type of cash flow that is used in the valuation: Equity Cash Flow (ECF), Capital Cash Flow (CCF), and Free Cash Flow (FCF). The three methods provide consistent valuations when applied correctly. Capital Cash Flows measure the cash flow available to both eqUity and debt holders. The benefits of tax deductible interest payments are included in the Capital Cash Flow. The appropriate discount rate for Capital Cash Flows is the pre-tax rate corresponds to the riskiness of the assets of the firm. The riskiness of the assets is relevant because the cash flow measure includes all of the cash flow generated by the assets and available to all providers of capital. Equity Cash Flows measure the cash flow available to stockholders after payments to debt holders are deducted from operating cash flows. The payments to debt holders, sometimes called Debt Cash Flows, include interest and principle payments. Equity Cash Flows equal Capital Cash Flows minus Debt Cash Flow. Because debt cash flows are paid out of operating cash flows before equity cash flows, debt cash flows are safer than equity cash flows. That means that Equity Cash Flows are riskier than cash flow measures that combine Debt Cash Flows and Equity Cash Flo