Equity Cash Flow Research Articles

Optimal capital structures for private firms

This article shows how to construct an optimal capital structure for a private firm. Since the agents who supply the firm’s capital are risk averse, they diversify by holding both debt and equity. This can mitigate, or even eliminate, the classical risk shifting problem. There is a wealth effect since the optimal capital structure, which can involve multiple types of debt, depends on the amount of wealth that each agent contributes to the firm. However, it is shown that the agents’ equity holdings do not depend on the contributed amounts of wealth. Thus the model can produce a wedge between ownership rights and equity cashflow rights. These features are illustrated in a firm with three agents.

Cyclicality, Performance Measurement, and Cash Flow Liquidity in Private Equity

We study the liquidity properties of private equity cash flows using data from 837 buyout and venture capital funds from 1984-2010. Most cash flow variation at a point in time is diversifiable – either idiosyncratic to a given fund or explained by the fund’s age. Both capital calls and distributions also have a procyclical systematic component. Distributions are more sensitive than calls, implying procyclical aggregate net cash flows. A consequence is that the well-known finding that funds raised in hot markets underperform in absolute terms is sharply attenuated when comparing to public equities. Consistent with a liquidity premium for calling capital in bad times, we find that funds with a relatively high propensity to do so perform better in both absolute and relative terms. Venture capital cash flows and performance are considerably more cyclical than buyout, and the links between cyclical cash flows and performance are likewise stronger.

Valuation of an Equity Interest

The equity cash flow approach to valuing an equity interest is intuitive, rigorous, and practical, and is easily implemented using historical and forecasted statements of cash flows. This method is compared with popular alternatives. The equity cash flow equation for valuing equity is derived taking into account employee compensation expense in the form of equity participation (stock options and stock grants). This is of particular interest in light of the importance of options and grants as a form of compensation.

Net Income, Cash Flows, Reduced Balance Sheet and WCR (Working Capital Requirements)

The Spanish version of this paper is available at: http://ssrn.com/abstract=895267. The net income of a company in a given year is an arbitrary number which depends on several decisions on the accounting of expenses and revenues. By contrast, each cash flow (money going out of the cash of the company into someone's pocket: shareholders, debt owners...) is a single number not subject to any particular criterion. The case of Madera Inc. is presented and different flows are calculated. The Equity Cash Flow (ECF) is the money which comes out of the cash and gets into the pockets of the shareholders. The FCF (Free Cash Flow) is the hypothetical ECF if the company had no debt. The Capital Cash flow is the Debt Cash Flow plus the Equity Cash Flow. The Debt Cash Flow consists of the sum of the interest plus the repayment of principal (or less the increase in principal). The reduced balance sheet and the WCR (“Working Capital Requirements”) are also calculated. They allow us to interpret more easily and quicker the accounting statements.The following questions arise: Does the dividend come from the net income? Where are the retained earnings and the reserves? What is the depreciation?

Should Practitioners (Continue to) Use a Single Discount Rate in Large-Scale Project Valuation?

A popular, large-scale, project valuation technique relies on discounting equity cash flows using the cost of equity as a discount rate. Practitioners often use a single discount rate (SDR). Academic professionals, however, argue for the use of multiple discount rates (MDR) to reflect changes in the project’s leverage and overall risk. This article explores the state of the art in MDR valuation, reconciles the MDR and SDR valuation approaches, and develops a practical example applying some of the simplest MDR techniques available. Some conclusions are drawn regarding which approach may offer the better results.

Dividends and Share Repurchases

The share value is the present value of the expected equity cash flows, and the two main components of equity cash flows are dividends and share repurchases. We focus on the evolution of dividends and share repurchases on the U.S. stock market, although we also provide some data about other countries. We show the evolution of the dividend yield of GE, Boeing and Coca-Cola. We compare the evolution of the yield on 30-year Government bonds and the dividend yield in the United States. Both yields have fallen in the last 30 years. We compare the evolution of the dividends per share of Coca-Cola and Pepsico with the earnings per share, and we calculate the expected dividend growth of Coca-Cola and Pepsico implicit in the market prices.

Auditor quality effects on the relationship between accruals, cash flows and equity returns: a variance decomposition analysis

In this paper, we examine the relative importance of the cash flow and accruals components of earnings in explaining the variation in UK company equity returns, together with the extent to which these relationships vary by auditor quality. We use a multivariate time-series approach that can be reconciled to a log-linear theoretical valuation model and, unlike the standard linear regression of returns on earnings components, accommodates time-varying discount rates. Based on a decomposition of the variance of equity returns, cash flows and accruals, our results indicate that both cash flow news and accruals news are important drivers of UK equity returns, although cash flows are more influential than accruals. We also find that variation in both earnings components has a more significant effect on returns for clients of large auditors. Finally, our results provide mixed evidence on the question of whether the impact of auditor quality is highest for the accruals component of earnings.

Capital Structure and Value

This note presents a series of questions that leads students through the essential logic linking capital structure and firm value. It begins with a nontax benchmark, then proceeds through valuations with tax deductibility based on (1) a discount rate with tax effects built in (discount free cash flow at the WACC), (2) the valuation of specific claims (value equity cash flows and debt cash flows separately), and (3) the valuation of types of cash flow (value assets and interest tax shields separately). The note concludes by linking these concepts to stock price effects around recapitalizations. Financial risk (leverage effects on CAPM betas) is also introduced and illustrated.

Valuing companies by cash flow discounting: ten methods and nine theories

PurposeThe aim of this paper is to answer the question: Do discounted cash flows valuation methods provide always the same value?Design/methodology/approachThis paper is a summarized compendium of ten methods including: free cash flow; equity cash flow; capital cash flow; adjusted present value; business's risk‐adjusted free cash flow and equity cash flow; risk‐free rate‐adjusted free cash flow and equity cash flow; economic profit; and economic value added.FindingsAll ten methods always give the same value.Research limitations/implicationsThe disagreements among the various theories of firm valuation arise from the calculation of the value of the tax shields (VTS). The paper analyses nine different theories.Originality/valueThe paper is an analysis of ten methods of company valuation using discounted cash flows and nine different theories about the VTS.

New Tests of Market Efficiency Using Fully Identifiable Equity Cash Flows

Despite the fact that stock market efficiency has been tested in numerous studies and through several approaches, it is still not clear to what extent stock prices correctly reflect information. The inability to test whether stock prices correctly incorporate information stems from the infinite life of a corporation, which inhibits complete measurement of realized corporate cash flows. Using a unique dataset of publicly traded venture capital funds, we examine the relation between investor reaction to announcements of identifiable investments by funds and realized results of these investments. The advantage of our dataset is that these investments retain their original structure until fully realized. Our results indicate that, upon the announcement of investments, investors are able to properly forecast the eventual realizations of these investments and share prices reflect these forecasts.

Vesting and Control in Venture Capital Contracts

Vesting of equity payments to an entrepreneur, which is a form of time-contingent compensation, is very common in venture capital contracts. Empirical research suggests that vesting is used to help overcome asymmetric information and agency problems. We show in a theoretical model that vesting equity to an entrepreneur over a long period of time acts as a screening device against a bad entrepreneur type. But incomplete contracts due to hold-up by the venture capitalist imply that equity compensation, in the form of either short-term or long-term vesting, cannot provide standard contractible equity incentives for the entrepreneur to take an unobservable action involving effort. We introduce a new model of effort based on a verifiable choice of an effort-intensive project, for which the short-term vesting of equity can provide incentives, but which results in a trade-off between incentives and screening. Contingent control rights are a substitute for short-term vesting and provide the largest incentives for effort by fully protecting the entrepreneur from hold-up. We also show that a new link between equity cash flow claims and control rights is that residual equity control rights over the firm are necessary to protect residual equity claims from hold-up.

Equity Premium: Historical, Expected, Required and Implied

The equity premium designates four different concepts: Historical Equity Premium (HEP); Expected Equity Premium (EEP); Required Equity Premium (REP); and Implied Equity Premium (IEP). We highlight the confusing message of the textbooks and academic articles regarding the equity premium and its evolution. The confusion arises from not distinguishing among the four concepts and from not recognizing that although the HEP is equal for all investors, the REP, the EEP and the IEP are different for different investors. There is a kind of schizophrenic approach to valuation: while all authors admit different expectations of equity cash flows, most authors look for a unique discount rate. It seems as if the expectations of equity cash flows are formed in a democratic regime, while the discount rate is determined in a dictatorship. A unique IEP requires assuming homogeneous expectations for the expected growth (g), but we show that there are several pairs (IEP, g) that satisfy current prices. We claim that different investors have different REPs and that it is impossible to determine the REP for the market as a whole, because it does not exist. We also investigate the relationship between (IEP - g) and the risk free rate.

Valuing Companies with a Fixed Book-Value Leverage Ratio

We develop valuation formulae for a company that maintains a fixed book-value leverage ratio and claim that it is more realistic than to assume, as Miles-Ezzell (1980), a fixed market-value leverage ratio. The value of tax shields depends only on the present value of the net increases of debt. The value of tax shields in a world with no leverage cost is the tax rate times the current debt plus the present value of the net increases of debt. We also show that the appropriate discount rates for the equity cash flows and for the expected value of the equity are different. It is more realistic to assume that a company maintains a fixed book-value leverage ratio than to assume, as Miles-Ezzell (1980) do, that the company maintains a fixed market-value leverage ratio because the amount of debt does not depend on the movements of the stock market, it is easier to follow for non quoted companies, and managers should prefer so because the value of tax shields is more valuable.

Discounted Cash Flow Valuation Methods: Examples of Perpetuities, Constant Growth and General Case

This paper explores the discounted cash flow valuation methods. We start the paper with the simplest case: no-growth, perpetual-life companies. Then we will study the continuous growth case and, finally, the general case. The different concepts of cash flow used in company valuation are defined: equity cash flow (ECF), free cash flow (FCF), and capital cash flow (CCF). Then the appropriate discount rate is determined for each cash flow depending on the valuation method used. Our starting point will be the principle by which the value of a company's equity is the same, whichever of the four traditional discounted cash flow formulae is used. This is logical: given the same expected cash flows, it would not be reasonable for the equity's value to depend on the valuation method.

Vesting and Control in Venture Capital Contracts

Vesting of equity payments to an entrepreneur, which is time contingent compensation, is ubiquitous in venture capital contracts and has been shown empirically to be of economic importance. We show that vesting equity to an entrepreneur over a longer period of time, late vesting, acts as a screening device against bad entrepreneur types. But if contracts are incomplete such that payments and vesting cannot initially be contracted upon later outcomes, then late vesting gives lower effort incentives than early (short time-period) vesting since it is subject to holdup by the venture capitalist. Comparative statics show how equilibrium outcomes of screening, effort and assignment of control rights vary based on the ex-ante probability and the ex-interim signal of the entrepreneur's type. Control rights are a substitute for early vesting and allow for the largest effort incentives by fully protecting the entrepreneur from holdup. We also find that a new explanation for the link between equity control rights and equity cash flow claims is that residual equity control rights over the firm are necessary to protect residual equity claims from holdup.

Equivalence of Ten Different Methods for Valuing Companies by Cash Flow Discounting

This paper shows that ten methods on company valuation using cash flow discounting (WACC; equity cash flow; capital cash flow; adjusted present value; residual income; EVA; business's risk-adjusted equity cash flow; business's risk-adjusted free cash flow; risk-free-adjusted equity cash flow; and risk-free-adjusted free cash flow) always give the same value when identical assumptions are used. This result is logical, since all the methods analyze the same reality based upon the same assumptions; they only differ in the cash flows taken as the starting point for the valuation. We present all ten methods allowing the required return to debt being different from the cost of debt. Seven methods require an iterative process. Only APV and the business risk-adjusted cash flows methods do not require iteration.

Cash Flow is a Fact. Net Income is Just an Opinion

We use three different definitions of cash flow: equity cash flow (ECF), free cash flow (FCF) and capital cash flow (CCF). We also answer to the question: When net income is equal to the equity cash flow? When making projections, dividends and other payments to shareholders forecasted must be exactly equal to expected equity cash flows. May a company have positive net income and negative cash flows? Of course: one has only to think of the many companies that file for voluntary reorganization after having a positive net income. This is precisely what happens to the company AlphaCommerce that we show as an example. A company’s net income is a quite arbitrary figure obtained after assuming certain accounting hypotheses regarding expenses and revenues (.one of several that can be obtained, depending on the criteria applied). However, the ex-post cash flow is an objective measure, a single figure that is not subject to any personal criterion.

Three Residual Income Valuation Methods and Discounted Cash Flow Valuation

In this paper we show that the Residual Income models for equity valuation always yield the same value as the Discounted Cash Flow Valuation models. We use three residual income measures: Economic Profit, Economic Value Added (EVA) and Cash Value Added. We also show that economic profit and EVA are different, although Copeland, Koller and Murrin (2000, page 55) say that economic profit is a synonym of EVA. Specifically, we first show that the present value of the Economic Profit discounted at the required return to equity plus the equity book value equals the value of equity. The value of equity is the present value of the Equity cash flow discounted at the required return to equity. Then, we show that the present value of the EVA discounted at the WACC plus the enterprise book value (equity plus debt) equals is the enterprise market value. The enterprise market value is the present value of the Free cash flow discounted at the WACC. Then, we show that the present value of the Cash Value Added discounted at the WACC plus the enterprise book value (equity plus debt) equals is the enterprise market value. The enterprise market value is the present value of the Free cash flow discounted at the WACC.

Evaluating CDO Equity Tranches

CDOs have grown to be an important part of the asset-backed securities market, accounting for some 15% of new issuance. In this article we look at where CDO equity cash flows come from and how to evaluate them. We then do a brief review of relative attractiveness of equity cash flows backed by different collateral.

Identifying the Sources of Gains From Takeovers

In the research literature on UK take-overs there seems to be an appar-ent conundrum. First, it appears that, in general, the market anticipatesoverall equity cash flow gains from a take-over in the sense that theshare price of the acquiree firm typically increases relative to someappropriately market-adjusted benchmark over the period of time fromthe announcement of the take-over to the date when the take-over offeris declared unconditional while the share price of the acquirer firm doesnot decrease over the same period of time