Capital Cash Flows: a Simple Approach to Valuing Risky Cash Flows Richard S. Ruback
Capital Cash Flows: A Simple Approach to Valuing Risky Cash Flows
Richard S. Ruback*
This paper presents the Capital Cash Flow (CCF) method for valuing risky cash flows. I show that the CCF method is equivalent to discounting Free Cash Flows (FCF) by the weighted average cost of capital. Because the interest tax shields are included in the cash flows, the CCF approach is easier to apply whenever debt is forecasted in levels instead of as a percent of total enterprise value. The CCF method retains its simplicity when the forecasted debt levels and the implicit debt-to-value ratios change throughout forecast period. The paper also compares the CCF method to the Adjusted Present Value (APV) method and provides consistent leverage adjustment formulas for both methods.
The most common technique for valuing risky cash flows is the Free Cash Flow (FCF) method. In that method, interest tax shields are excluded from the FCFs and the tax deductibility of interest is treated as a decrease in the cost of capital using the after-tax weighted average cost of capital (WACC). Because the WACC is affected by changes in capital structure, the FCF method poses several implementation problems in highly leveraged transactions, restructurings, project financings, and other instances in which capital structure changes over time. In these situations, the capital structure has to be estimated and those estimates have to be used to compute the appropriate WACC in each period. Under these circumstances, the FCF method can be used to correctly value the cash flows, but it is not straightforward. This paper presents an alternative method for valuing risky cash flows. I call this method the Capital Cash Flow (CCF) method, because the cash flows include all of the cash available to capital providers, including the interest tax shields. In a capital structure with only ordinary debt and common equity, CCFs equal the flows available to equity—NI plus depreciation less capital expenditure and
Richard S. Ruback*
This paper presents the Capital Cash Flow (CCF) method for valuing risky cash flows. I show that the CCF method is equivalent to discounting Free Cash Flows (FCF) by the weighted average cost of capital. Because the interest tax shields are included in the cash flows, the CCF approach is easier to apply whenever debt is forecasted in levels instead of as a percent of total enterprise value. The CCF method retains its simplicity when the forecasted debt levels and the implicit debt-to-value ratios change throughout forecast period. The paper also compares the CCF method to the Adjusted Present Value (APV) method and provides consistent leverage adjustment formulas for both methods.
The most common technique for valuing risky cash flows is the Free Cash Flow (FCF) method. In that method, interest tax shields are excluded from the FCFs and the tax deductibility of interest is treated as a decrease in the cost of capital using the after-tax weighted average cost of capital (WACC). Because the WACC is affected by changes in capital structure, the FCF method poses several implementation problems in highly leveraged transactions, restructurings, project financings, and other instances in which capital structure changes over time. In these situations, the capital structure has to be estimated and those estimates have to be used to compute the appropriate WACC in each period. Under these circumstances, the FCF method can be used to correctly value the cash flows, but it is not straightforward. This paper presents an alternative method for valuing risky cash flows. I call this method the Capital Cash Flow (CCF) method, because the cash flows include all of the cash available to capital providers, including the interest tax shields. In a capital structure with only ordinary debt and common equity, CCFs equal the flows available to equity—NI plus depreciation less capital expenditure and
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