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Article
Publication date: 6 January 2022

Denis Mike Becker

The purpose of this paper is to establish the flow-to-equity method, the free cash flow (FCF) method, the adjusted present value method and the relationships between these methods…

Abstract

Purpose

The purpose of this paper is to establish the flow-to-equity method, the free cash flow (FCF) method, the adjusted present value method and the relationships between these methods when the FCF appears as an annuity. More specifically, we depart from the two most widely used evaluation settings. The first setting is that of Modigliani and Miller who based their analysis on a stationary FCF. The second setting is that of Miles and Ezzell who worked with an FCF that represents an autoregressive possess of first order.

Design/methodology/approach

Inspired by recent observations in the literature concerning cash flows, discount rates and values in discounted cash flow (DCF) methods, we mathematically derive DCF valuation formulas for annuities.

Findings

The following relationships are established: (a) the correct discount rate of the tax shield when the free cash flow takes the form of a first-order autoregressive annuity, (b) the direct valuation of the tax shield from the free cash flow for a first-order autoregressive annuity, (c) the correct translation from the required return on unlevered equity to the levered equity, when the free cash flow is a stationary annuity and (d) direct calculation of the unlevered and levered firm values and the value of the tax shield for a stationary annuity.

Originality/value

Until now the complete set of formulas for the valuation of stochastic annuities by different DCF methods has not been established in the literature. These formulas are developed here. These formulas are important for practitioners and academics when it comes to the valuation of cash flows of finite lifetime.

Details

Managerial Finance, vol. 48 no. 3
Type: Research Article
ISSN: 0307-4358

Keywords

Article
Publication date: 1 January 2005

Tariq Ismail and Melinda Cline

This research furthers scholarly discourse which discusses the most effective way(s) to calculate investment returns under conditions of continuous and/or discrete cash flows with…

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Abstract

Purpose

This research furthers scholarly discourse which discusses the most effective way(s) to calculate investment returns under conditions of continuous and/or discrete cash flows with continuous and/or discrete discounting.

Design/methodology/approach

Discusses Pogue's work on the methods for investment analysis.

Findings

Pogue's article of discrete versus continuous calculation of investment returns discusses limitations of the traditional assumption that cash flows in investment appraisal occur at the end of each period and points to a more realistic assumption that cash flows occur on a continuous basis. Pogue then proposes a formula for managers to use when calculating investment returns. Finds that Pogue's suggested method of calculation is neither supported by prior literature nor sound in its implications.

Originality/value

Provides further analysis of discrete and continuous discounting models in investment decisions.

Details

Managerial Auditing Journal, vol. 20 no. 1
Type: Research Article
ISSN: 0268-6902

Keywords

Article
Publication date: 2 October 2007

Pablo Fernández

The aim of this paper is to answer the question: Do discounted cash flows valuation methods provide always the same value?

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Abstract

Purpose

The aim of this paper is to answer the question: Do discounted cash flows valuation methods provide always the same value?

Design/methodology/approach

This paper is a summarized compendium of ten methods including: free cash flow; equity cash flow; capital cash flow; adjusted present value; business's risk‐adjusted free cash flow and equity cash flow; risk‐free rate‐adjusted free cash flow and equity cash flow; economic profit; and economic value added.

Findings

All ten methods always give the same value.

Research limitations/implications

The disagreements among the various theories of firm valuation arise from the calculation of the value of the tax shields (VTS). The paper analyses nine different theories.

Originality/value

The paper is an analysis of ten methods of company valuation using discounted cash flows and nine different theories about the VTS.

Details

Managerial Finance, vol. 33 no. 11
Type: Research Article
ISSN: 0307-4358

Keywords

Article
Publication date: 27 September 2021

Stephen Gray, Jason Hall, Grant Pollard and Damien Cannavan

In the context of public-private partnerships (PPPs), it has been argued that the standard valuation framework produces a paradox whereby government appears to be made better off…

Abstract

Purpose

In the context of public-private partnerships (PPPs), it has been argued that the standard valuation framework produces a paradox whereby government appears to be made better off by taking on more systematic risk. This has led to a range of approaches being applied in practice, none of which are consistent with the standard valuation approach. The purpose of this paper is to demonstrate that these approaches are flawed and unnecessary.

Design/methodology/approach

The authors step through the proposed alternative valuation approaches and demonstrate their inconsistencies and illogical outcomes, using theory, logic and mathematical proof.

Findings

In this paper, the authors demonstrate that the proposed (alternative) approaches suffer from internal inconsistencies and produce illogical outcomes in some cases. The authors also show that there is no problem with the current accepted theory and that the apparent paradox is not the result of a deficiency in the current theory but is rather caused by its misapplication in practice. In particular, the authors show that the systematic risk of cash flows is frequently mis-estimated, and the correction of this error solves the apparent paradox.

Practical implications

Over the past 20 years, PPP activity around the globe amounts to many billions of dollars. Decisions on major infrastructure funding are of enormous social and economic importance.

Originality/value

To the best of the authors’ knowledge, this study is the first to demonstrate the flaws and internal inconsistencies with proposed valuation framework alternatives for the purposes of evaluating PPPs.

Details

Accounting Research Journal, vol. 34 no. 6
Type: Research Article
ISSN: 1030-9616

Keywords

Article
Publication date: 5 October 2020

Denis Mike Becker

The primary purpose of this paper is to develop the translation formula between the required return on unlevered and levered equity for the specific case where cash flows have a…

Abstract

Purpose

The primary purpose of this paper is to develop the translation formula between the required return on unlevered and levered equity for the specific case where cash flows have a finite lifetime and the flow to debt is prespecified. The secondary purpose of this paper is to underpin the importance of the type of stochasticity of cash flows for translation formulas. A general derivation of such formulas and the discount rate in the free cash flow approach is shown.

Design/methodology/approach

The paper starts with the same assumptions that have been applied by Modigliani and Miller (1963), Miles and Ezzell (1980) and other researchers. Then the paper develops the mathematical foundations to apply a deterministic backward-iterative scheme for valuing cash flows. After stating the valuation formulas for levered and unlevered equity, debt and tax shields, the authors mathematically derive the relationship between the unlevered return and levered return on equity.

Findings

Conventional translation formulas apply to very special cases. They can generally not be used for projects with nonconstant leverage and a finite lifetime. In general, translation formulas depend on continuing values, cash flows, leverage, taxation, risk-free rate, etc. In this paper, the translation depends on the structure of the debt in addition to the well-known parameters in conventional formulas. This paper formula contains the Modigliani-Miller translation formula as a special case.

Originality/value

The authors develop a novel formula for the translation of the required return on unlevered to levered equity. With this formula, the authors offer a solution for the consistent valuation of cash flows with a limited lifetime and given debt financing.

Details

Managerial Finance, vol. 47 no. 4
Type: Research Article
ISSN: 0307-4358

Keywords

Article
Publication date: 6 February 2009

Patrick McAllister and Pavlos Loizou

This paper aims to analyse the appraisal of a specialised form of real estate – data centres – that has a unique blend of locational, physical and technological characteristics…

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Abstract

Purpose

This paper aims to analyse the appraisal of a specialised form of real estate – data centres – that has a unique blend of locational, physical and technological characteristics that differentiate it from conventional real estate assets. Market immaturity, limited trading and a lack of pricing signals enhance levels of appraisal uncertainty and disagreement relative to conventional real estate assets.

Design/methodology/approach

Given the problems of applying standard discounted cash flow, an approach to appraisal is proposed that uses pricing signals from traded cash flows that are similar to the cash flows generated from data centres. Based on “the law of one price”, it is assumed that two assets that are expected to generate identical cash flows in the future must have the same value now. It is suggested that the expected cash flow of assets should be analysed over the life cycle of the building. Corporate bond yields are used to provide a proxy for the appropriate discount rates for lease income. Since liabilities are quite diverse, a number of proxies are suggested as discount and capitalisation rates including indexed‐linked, fixed interest and zero‐coupon bonds.

Findings

The application of conventional discounted cash flow approaches to the appraisal of data centres requires information about a wide range of inputs that is difficult to derive from market signals or estimate analytically. In practice, discounted cash flow appraisals of data centre facilities are forced to incorporate non‐market assumptions that are inevitably subjective. Cash flows from data centres tend to be more complicated because of the high levels of current and capital expenditure compared with conventional assets. This requires an understanding of the appraisal of liabilities as well as income. Whilst the use of price information from similar cash flows such as corporate bonds is helpful, there are rarely assets and liabilities that have identical cash flows and risks and some approximation is necessary.

Originality/value

The digitalisation of business and society has produced a different form of real estate asset that is specialised, physically complex and whose operation, maintenance and management require specialist staffing and high levels of current and capital expenditure. The complexity of the cash flows and the lack of active trading create significant appraisal problems. This paper proposes an alternative approach to appraisal that utilises external pricing signals to appraise the various incomes and costs.

Details

Journal of Property Investment & Finance, vol. 27 no. 1
Type: Research Article
ISSN: 1463-578X

Keywords

Article
Publication date: 1 February 1993

Richard Dobbins

Sees the objective of teaching financial management to be to helpmanagers and potential managers to make sensible investment andfinancing decisions. Acknowledges that financial…

6362

Abstract

Sees the objective of teaching financial management to be to help managers and potential managers to make sensible investment and financing decisions. Acknowledges that financial theory teaches that investment and financing decisions should be based on cash flow and risk. Provides information on payback period; return on capital employed, earnings per share effect, working capital, profit planning, standard costing, financial statement planning and ratio analysis. Seeks to combine the practical rules of thumb of the traditionalists with the ideas of the financial theorists to form a balanced approach to practical financial management for MBA students, financial managers and undergraduates.

Details

Management Decision, vol. 31 no. 2
Type: Research Article
ISSN: 0025-1747

Keywords

Article
Publication date: 1 January 1989

Colin Drury

It is apparent from the empirical studies in the UK and USA that incorrect approaches are frequently used to evaluate finance leases. Sykes (1975), Hull and Hubbard (1979) and…

Abstract

It is apparent from the empirical studies in the UK and USA that incorrect approaches are frequently used to evaluate finance leases. Sykes (1975), Hull and Hubbard (1979) and Drury and Braund (1989) in the UK and Ferrara et. al., (1980) in the USA have expressed concern regarding the methods which companies use to evaluate finance leases. For example Sykes (1975) found that only 19% of UK companies used DCF methods to evaluate leases. Hull and Hubbard (1979) observed that many companies used the implied rate of interest quoted from the lessor's leasing tables and compared this with the borrowing rate. However, these tables did not include tax cash flows and were therefore only applicable to a permanent non‐taxpaying organisation. In the most recent study Drury and Braund (1989) found that 41% of the 300 firms responding to a questionnaire used the wrong discount rate to evaluate finance leases and a further 14% used non‐discounting methods. The objective of this article is to explain how the lease or purchase decision should be evaluated. It will be shown that leasing should be compared with borrowing and three different methods of correctly evaluating the lease or borrow decision will be presented and reconciled.

Details

Managerial Finance, vol. 15 no. 1/2
Type: Research Article
ISSN: 0307-4358

Article
Publication date: 10 August 2010

Wayne Lonergan

This paper aims to identify conceptual changes in the practical application of asset impairment testing methods as required under IAS (International Accounting Standards) 36.

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Abstract

Purpose

This paper aims to identify conceptual changes in the practical application of asset impairment testing methods as required under IAS (International Accounting Standards) 36.

Design/methodology/approach

The paper explores general principles for an impairment testing framework, to address impairment issues that arise in valuation practice.

Findings

This paper shows that the way value in use is required to be assessed is technically flawed, prone to application error, and creates conceptual and financial mismatches with the requirements of other accounting standards.

Practical implications

From a practical perspective, the consequential scope for valuation errors is further exacerbated by the reluctance of company directors to accept the need for impairment and, in some cases, by gaming.

Originality/value

This paper provides a practitioner's viewpoint to impairment testing under the IAS, and identifies several inconsistencies with the application of the standard.

Details

Managerial Finance, vol. 36 no. 9
Type: Research Article
ISSN: 0307-4358

Keywords

Article
Publication date: 1 March 1997

Colin Drury and Mike Tayles

Surveys of capital budgeting practices in the UK and USA reveal a trend towards the increased use of more sophisticated investment appraisals requiring the application of…

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Abstract

Surveys of capital budgeting practices in the UK and USA reveal a trend towards the increased use of more sophisticated investment appraisals requiring the application of discounted cash flow (DCF) techniques. Several writers, however, have claimed that companies are underinvesting because they misapply or misinterpret DCF techniques. Such claims have been made on the basis of observations in only a few companies, or anecdotal evidence, without any supporting statistical evidence. Reports on a recent survey conducted by the authors which suggests that many UK firms are guilty of misapplying DCF techniques. Also provides evidence relating to some issues that have not been thoroughly examined in previous studies, namely the impact of company size and the relative importance that firms attach to different investment appraisal techniques.

Details

Management Decision, vol. 35 no. 2
Type: Research Article
ISSN: 0025-1747

Keywords

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