Page 325 - Encyclopedia of Business and Finance

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Finance

ISSUES IN APPLIED CORPORATE inputs. How is the cash-flow stream estimated from pres-
FINANCE AND VALUATION ent data? More important, are current and past dividends,
Estimation of the Cost of Capital. In recent decades, the- earnings, or cash flows the best indicators of that stream?
oretical breakthroughs in such areas as portfolio diversifi- These pragmatic issues determine which model should be
cation, market efficiency, and asset pricing have converged used. Although the dividend model is easy to use, it pres-
into compelling recommendations about the cost of capi- ents a conceptual dilemma. Finance theory says that divi-
tal to a corporation. The cost of capital is central to mod- dend policy is irrelevant. The model, however, requires
ern finance, touching on investment and divestment forecasting dividends to infinity or making terminal value
decisions, measure of economic profit, performance assumptions. Firms that currently do not pay dividends
appraisal, and incentive systems. Each year in the United are a case in point. Such firms are not valueless. In fact,
States, corporations undertake more than $500 billion in high-growth firms often pay no dividends, because they
expenditures, so how firms estimate the cost is not a triv- reinvest all funds available to them. When firm value is
ial matter. A key insight from finance theory is that any estimated using a dividend discount model, it depends on
use of capital imposes an opportunity cost on investors; the dividend level of the firm after its growth stabilizes.
namely, funds are diverted from earning a return on the Future dividends depend on the earnings stream the firm
next-best equal risk investment. Since investors have will be able to generate. Thus, the firm’s expected future
access to a host of financial market opportunities, corpo- earnings are fundamental to such a valuation. Similarly,
rate use of capital must be benchmarked against these cap- for a firm paying dividends, the level of dividends may be
ital market alternatives. The cost of capital provides this a discretionary choice of management that is restricted by
benchmark. Unless a firm can earn in excess of its cost of available earnings. When dividends are not paid out, value
capital, it will not create economic profit or value for accumulates within the firm in the form of reinvested
investors. A recent survey of leading practitioners reported earnings. Alternatively, firms sometimes pay dividends
the following best practices: right up to bankruptcy. Thus, dividends may say more
about the allocation of earnings to different claimants
• Discounted cash flow (DCF) is the dominant than valuation. All three DCF approaches rely on a meas-
investment-evaluation technique ure of cash flows to the suppliers of capital (debt and
• Weighted average cost of capital (WACC) is the equity) to the firm. They differ only in the choice of meas-
dominant discount rate used in DCF analyses urement, with the dividend approach measuring the cash
flows directly and the others arriving at them in an indi-
• Weights are based on market, not book, value mixes
rect manner. The free cash-flow approach arrives at the
of debt and equity
cash-flow measure (if the firm is all-equity) by subtracting
• The after-tax cost of debt is predominantly based on investment from operating cash flows, whereas the earn-
marginal pretax costs, as well as marginal or statu- ings approach expresses dividends indirectly as a fraction
tory tax rates of earnings.
• The capital asset pricing model (CAPM) is the
dominant model for estimating the cost of equity The Capital Asset Pricing Model. This is a set of predic-
tions concerning equilibrium expected returns on risky
Discounted Cash Flow Valuation Models. The parame- assets. Harry Markowitz established the foundation of
ters that make up the DCF model are related to risk (the modern portfolio theory in 1952. The CAPM was devel-
required rate of return) and the return itself. These mod- oped twelve years later in articles by William Sharpe, John
els use three alternative cash-flow measures: dividends, Lintner, and Jan Mossin. Almost always referred to as
accounting earnings, and free cash flows. Just as DCF and CAPM, it is a centerpiece of modern financial economics.
asset-based valuation models are equivalent under the The model provides a precise prediction of the relation-
assumption of perfect markets, dividends, earnings, and ship that we should observe between the risk of an asset
free cash-flow measures can be shown to yield equivalent and its expected return. This relationship serves two vital
results. Their implementation, however, is not straightfor- functions. First, it provides a benchmark rate of return for
ward. First, there is inherent difficulty in defining the cash evaluating possible investments. For example, if one is
flows used in these models. Which cash flows and to analyzing securities, one might be interested in whether
whom do they flow? Conceptually, cash flows are defined the expected return we forecast for a stock is more or less
differently depending on whether the valuation objective than its “fair” return given its risk. Second, the model
is the firm’s equity or the value of the firm’s debt plus helps one to make an educated guess as to the expected
equity. Assuming that one can define cash flows, one is left return on assets that have not yet been traded in the mar-
with another issue. The models need future cash flows as ketplace. For example, how does one price an initial pub-

302 ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION