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Two Different Ways of Treating Corporate Cash in FCF Valuations—and the Importance of Getting the Cost of Capital Right
Author(s) -
Easton Peter D.,
Sommers Gregory A.
Publication year - 2017
Publication title -
journal of applied corporate finance
Language(s) - English
Resource type - Journals
eISSN - 1745-6622
pISSN - 1078-1196
DOI - 10.1111/jacf.12251
Subject(s) - free cash flow , cash flow statement , valuation (finance) , weighted average cost of capital , cash flow , corporate finance , economics , business , finance , operating cash flow , financial statement analysis , financial statement , equity (law) , discounted cash flow , cost of capital , cash flow forecasting , cash management , financial analysis , accounting , microeconomics , financial capital , audit , profit (economics) , capital formation , political science , law
The methods for calculating free cash flow presented in texts on financial statement analysis and valuation appear to be very different from those in corporate finance texts, causing some confusion among academics as well as practitioners. Financial statement analysis and valuation texts generally begin by valuing just the enterprise operations—that is, the entity that engages in the firm's primary revenue‐generating activities—and then adding back the value of its cash holdings and other financial assets. The corporate finance approach is typically to value all the assets together, including financial assets that are not used in the production of the goods and services provided by the firm. Using a simple example, the authors show that the valuation of the equity ownership of the firm should be the same for both methods of calculating free cash flow, provided the analyst makes the appropriate adjustments to the method for calculating the cost of capital (WACC) used to discount forecasted free cash flows to a present value.