Corporate Valuation

Master course
Academic year 2021-2022– 2nd semester

School of Economics and Management

Estimation of cash flows

Questions

Much of the tedium in valuation is associated with estimating cash flows, a necessary element of discounted cash
flow valuation. This chapter examines the process of estimating cash flows and establishes some general principles
which should be adhered to in all valuation models. The one overriding principle governing cash flow estimation is
the need to match cash flows to discount rates: equity cash flows to cost of equity; firm cash flows to cost of capital;
pre-tax cash flows to pre-tax rates; post-tax cash flows to post-tax rates; nominal cash flows to nominal rates; and real
cash flows to real rates. The process of estimating these cash flows is explained in detail in the pages that follow.

1. Cash Flows to Equity: Concepts

Which of the following is the best description of the free cash flow to equity?

(a) It is the cash that equity investors can take out of the firm.
(b) It is the dividend that is paid to stockholders.
(c) It is the cash that equity investors can take out of the firm after financing investment needed to sustain
future growth.
(d) It is the cash left over after meeting debt payments and paying taxes.
(e) None of the above.

2. Cash Flows: Concepts

Answer true or false to the following statements.

(a) The free cash flow to equity will always be higher than the net income of the firm, because depreciation
is added back.
(b) The free cash flow to equity will always be higher than the dividend.
(c) The free cash flow to equity will always be higher than cash flow to the firm, because the latter is a
pre-debt cash flow.
(d) The entire free cash flow to equity cannot be paid out as a dividend because some of it has to be
invested in new projects.

3. The Effects of Inflation

Answer true or false to the following statements relating to the effect of inflation on cash flows and value.

(a) Discounting nominal cash flows at the real discount rate will result in too low an estimate of value.
(b) Discounting real cash flows at the nominal discount rate will result in too low an estimate of value.
(c) If done right, the value estimated should be the same if either real cash flows are discounted at the real
discount rate or nominal cash flows are discounted at the nominal discount rate.
(d) If companies can raise prices at the same rate as inflation, their value should not be affected by changes
in the inflation rate.

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 (e) Inflation should increase the value of stocks because it increases expected future cash flows.

4. Estimating Cash Flows: Diebold Incorporated

Diebold Incorporated manufactures, markets, and services automated teller machines in the United States.
The following are selected numbers from the financial statements for 1992 and 1993 (in millions):
1992 1993
Revenues $544.0 $620.0
(Less) Operating Expenses ($465.1) ($528.5)
(Less) Depreciation ($12.5) ($14.0)
= Earnings before Interest and Taxes $66.4 $77.5
(Less) Interest Expenses ($0.0) ($0.0)
(Less) Taxes ($25.3) ($29.5)
= Net Income $41.1 $48.0
Working Capital $175.0 $240.0
The firm had capital expenditures of $15 million in 1992 and $18 million in 1993. The working capital in
1991 was $180 million.

(a) Estimate the cash flows to equity in 1992 and 1993.

(b) What would the cash flows to equity in 1993 have been if working capital had remained at the same
percentage of revenue it was in 1992.

5. Estimating Cash Flows: Ryder System

Ryder System is a full-service truck leasing, maintenance, and rental firm with operations in North America and
Europe. The following are selected numbers from the financial statements for 1992 and 1993 (in millions).
1992 1993
Revenues $5,192.0 $5,400.0
(Less) Operating Expenses ($3,678.5) ($3848.0)
(Less) Depreciation ($573.5) ($580.0)
= EBIT $940.0 $972.0
(Less) Interest Expenses ($170.0) ($172.0)
(Less) Taxes ($652.1) ($670.0)
= Net Income $117.9 $130.0
Working Capital $92.0 ($370.0)
Total Debt $2,000 mil $2,200 mil
The firm had capital expenditures of $800 million in 1992 and $850 million in 1993. The working capital
in 1991 was $34.8 million, and the total debt outstanding in 1991 was $1.75 billion. There were 77 million
shares outstanding, trading at $29 per share.

(a) Estimate the cash flows to equity in 1992 and 1993.

(b) Estimate the cash flows to the firm in 1992 and 1993.
(c) Assuming that revenues and all expenses (including depreciation and capital expenditures) increase
6%, and that working capital remains unchanged in 1994, estimate the projected cash flows to equity
and the firm in 1994. (The firm is assumed to be at its optimal financial leverage.)
(d) How would your answer in (c) change if the firm planned to increase its debt ratio in 1994 by financing
75% of its capital expenditures (net of depreciation) with new debt issues?

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6. Estimating Cash Flows: Occidental Petroleum
Occidental Petroleum produces and markets crude oil. The following are selected numbers from the financial
statements for 1992 and 1993 (in millions).
1992 1993
Revenues $8,494.0 $9,000.0
(Less) Operating Expenses ($6,424.0) ($6,970.0)
(Less) Depreciation ($872.0) ($860.0)
= EBIT $1,198.0 $1,170.0
(Less) Interest Expenses ($510.0) ($515.0)
(Less) Taxes ($362.0) ($420.0)
= Net Income $326.0 $235.0
Working Capital ($45.0) ($50.0)
Total Debt $5.4 billion $5.0 billion
The firm had capital expenditures of $950 million in 1992 and $1 billion in 1993. The working capital in
1991 was $190 million, and the total debt outstanding in 1991 was $5.75 billion. There were 305 million
shares outstanding, trading at $21 per share.

(a) Estimate the cash flows to equity in 1992 and 1993.

(b) Estimate the cash flows to the firm in 1992 and 1993.
(c) Assuming that revenues and all expenses (including depreciation and capital expenditures) increase
4%, and that working capital remains unchanged in 1994, estimate the projected cash flows to equity
and the firm in 1994. (The firm is assumed to be at its optimal financial leverage.)
(d) How would your answer in (c) change if the firm planned to reduce its debt ratio in 1994 by financing
100% of its capital expenditures (net of depreciation) with new equity issues?

7. Inflation and Value

Watts Industries, a manufacturer of valves for industrial and residential use, had the following projected free
cash flows to equity per share for the next five years, in nominal terms.
Year FCFE/sh Terminal Value
1 $1.12
2 $1.25
3 $1.40
4 $1.57
5 $1.76 $23.32
The terminal price is based upon a stable nominal growth rate of 6% a year after year 5. The discount rate,
based upon financial market rates, is 14%, and the expected inflation rate is 3%.

(a) Estimate the value per share, using nominal cash flows and the nominal discount rate.
(b) Estimate the value per share, using real cash flows and the real discount rate.

8. After-tax and Pre-tax Valuation

Consider the example of Polaroid Corporation. The stock is trading at $37.00 per share currently. The
expected dividends, prior to personal taxes, as well as the expected terminal price, are given below:

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 Year Expected DPS Terminal Price
1 $0.67
2 $0.75
3 $0.84
4 $0.94
5 $1.06 $62.79
The expected return, prior to personal taxes, on Polaroid is 13%, of which 1.81% is expected to come from
dividends. An investor facing a tax rate of 36% on dividends and 25% on capital gains is considering investing
in the stock.

(a) What is the expected return, after personal taxes, to this investor?
(b) What are the expected dividends and terminal price, after personal taxes, to this investor?
(c) What is the value of the stock, using these after-personal-tax cash flows and discount rates?
(d) What is the value of the stock, using the pre-personal-tax cash flows and discount rates?

9. Terminal Values for Cash Flow Calculation

The terminal value in a capital budgeting project is generally much lower than the initial investment. The
terminal price in a stock valuation is generally much higher than the initial investment. How would you
explain the difference?

From Valuation Problem Sets, by A. Damodaran, available at https://pages.stern.nyu.edu/~adamodar/New_Home_

Page/problems/dcfprob.htm