Abstract
AbstractThis paper describes a simple way to integrate the debt tax shield into an accounting-based valuation model. The market value of equity is determined by forecasting residual operating income, which is calculated by charging operating income for the operating assets at a required return that accounts for the tax benefit that comes from borrowing to raise cash for the operations. The model assumes that the firm maintains a deterministic financial leverage ratio, which tends to converge quickly to typical steady-state levels over time. From a practical point of view, this characteristic is of particular help, because it allows a continuing value calculation at the end of a short forecast period.
Highlights
During the past decade, accounting-based valuation has increasingly been advocated as a practical alternative to discounted cash flow analysis (Fairfield and Yohn 2001; Penman 2006, and Ohlson and Gao 2006)
Because it focuses on accrual accounting, the latter is of particular help in analyzing financial statements and, presumably more useful for the practical task of evaluating firms (Penman and Sougiannis 1998; Penman 2001)
Financial leverage is defined as the proportion of operations that is financed through debt, where both variables are measured in terms of book values
Summary
During the past decade, accounting-based valuation has increasingly been advocated as a practical alternative to discounted cash flow analysis (Fairfield and Yohn 2001; Penman 2006, and Ohlson and Gao 2006). It is well recognized that the discounted cash flow model is theoretically equivalent to the residual income concept. Because it focuses on accrual accounting, the latter is of particular help in analyzing financial statements and, presumably more useful for the practical task of evaluating firms (Penman and Sougiannis 1998; Penman 2001). A forecast of operating residual income involves a forecast of operating profitability and growth in operating assets They showed that there is a tendency for many of the relevant ratios to revert to typical values over time, which is useful since practical analysis requires a continuing value calculation at the end of the forecast period
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