610 Making Key Strategic Decisions
A common error in the income approach to valuation is improperly match-
ing the income stream and discount rate. The equity net cash f low represents
the return on investment to the equity holders. Thus, the appropriate discount
rate in the DCF model is the company’s cost of equity. The invested capital net
cash f low is the rate of return to all holders of invested capital and, therefore,
the company’s weighted average cost of capital should be used.
Projected Financial Statements
Management of ACME prepared a financial projection and discusses it and the
underlying assumptions with Victor ia. Management’s financial projections are
presented in Exhibits 18.5, 18.6, and 18.7. Key assumptions incorporated into
the projections include:
- Sales would grow 12% in 2001 and 2002, 11% in 2003 and 2004, and 10%
in 2005. - Costs of goods sold are 69% of sales.
- Operating expenses (exclusive of of ficers’ salar ies) are 12% of sales.
- Officers’ salaries (at market) are 3.1% of sales.
- The 2001 capital expenditures are $2.8 million and increase thereafter
5% per year. - The company needs a minimum cash balance of $200,000.
Invested Capital Net Cash Flow
After-tax net income
+ Depreciation and amor tication (noncash) ex penses
− Capital expenditures
− Increases (or + decreases) in working capital requirements
+ Interest expense ×(1 minus tax rate)
=Net cash f low to holders of total invested capital (debt and
equity)Equity Net Cash Flow
After-tax net income
+Depreciation and amortization (noncash) expenses
−Capital expenditures
−Increases (or + decreases) in working capital requirements
+Increases (or −decreases) in long-term debt
=Net cash f low to equity holdersApplication of DCF Model
Type of Type of
Income Stream Discount Rate
Equity net cash f low Cost of equity
Invested capital net cash f low Weighted average cost of capital