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Capital Cash Flows: A Simple Approach to Valuing Risky Cash Flows

Author(s): Richard S. Ruback
Source: Financial Management, Vol. 31, No. 2 (Summer, 2002), pp. 85-103
Published by: Wiley on behalf of the Financial Management Association International
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Cash

Capital
to

A

Flows:

Valuing

Risky

Simple
Cash

Approach
Flows

RichardS. 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 throughoutforecast 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 WACCis affected by changes in capital structure, the FCF
method poses several implementationproblems 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 appropriateWACC 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 the increase in working capital-plus the interest paid to debtholders.
The interest tax shields decrease taxable income, decrease taxes and, thereby, increase after-tax
cash flows. In other words, CCFs equal FCFs plus the interest tax shields. Because the interest
tax shields are included in the cash flows, the appropriate discount rate is before-tax and
corresponds to the riskiness of the assets.
Although the FCF and CCF methods treat interest tax shields differently, the two methods
are algebraically equivalent. In other words, the CCF method is a different way of valuing cash
flows using the same assumptions and approachas the FCF method. The advantage of the CCF
method is its simplicity. Whenever debt is forecasted in levels, instead of as a percent of total
enterprise value, the CCF method is much easier to use, because the interest tax shields are easy
to calculate and easy to include in the cash flows. The CCF method retains its simplicity when
the forecasted debt levels and the implicit debt-to-value ratios change throughout the forecast
period. Also, the expected asset return depends on the riskiness of the asset and, therefore,
I would like to thank Malcolm Baker, Ben Esty, Stuart Gilson, Paul Gompers, Bob Holthausen, Chris Noe, Paul
Maleh, Scott Mayfield, Lisa Meulbroek, Stewart Myers, Denise Tambanis,Peter Tufano, the Editors, Lemma Senbet
and Alexander Triantis (the Editors), the referees, and seminar participants at Duke, Georgetown, and Harvard for
comments on earlier drafts and helpful discussions.
'RichardS. Rubackis the WillardPrescottSmithProfessorof CorporateFinance at HarvardBusinessSchool in Boston, MA.

FinancialManagement* Summer2002 * pages 85 - 103

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in Kaplan and Ruback(1995) to value highly leveredtransactions. no tax adjustment has to be made when calculating asset betas.1991 and Luehrman. to demonstrateits equivalencyto the FCF method. therefore. Hotchkiss. The risk of the interest tax shields.81 on Sat. then the more debt the firm uses in its financial structure.The more debt used. The CCF method avoids this complexity so that it is especially useful in valuing highly levered firms whose debt is usually forecastedin levels and whose capital structurechanges substantiallyover time. leverage does not alter the asset beta of the firm. This content downloaded from 146. Stewart Myers suggests the term "CompressedAPV" to describe the CCF method.86 FinancialManagement* Summer2002 does not change when capital structurechanges. As a result. This matching of the risk of the tax shields and the interest payment only occurs when the level of debt is fixed.'Also. The interest tax shields that are discounted by the cost of debt in the APV method are discounted by the cost of assets explicitly in the CCF method and implicitly in the FCF method. It results in a higher value than the CCF method. Because the WACCdepends on valueweights.69.andin Gilson. because it assigns a higher value to interest tax shields.1997). the risk of the shields depends on both the risk of the payment and systematic changes in the amount of debt. 1986) and to Stewart Myers' work on the Adjusted Present Value (APV) method (Myers. The primarycontributionsof this paper are to introducethe CCF method of valuation. 1995a. The analysis in this paper presents similar results for risky cash flows.andRuback(2000) to value firmsemergingfromChapter 1 reorganizations. namely. even when the debt is riskless. The CCF method. Because the interest tax shields have the same risk as the firm. the after-tax WACChas to be re-estimated every period. The intuition is that interest tax shields are realized roughly when interest is paid so that the risk of the shields matches the risk of the payment.50. The higher the value of the firm. because the level of debt is implicitly assumed to be a fixed dollar amount. assumes that debt is proportionalto value. like the FCF method. As a result. most descriptions of APV suggest discounting the interest tax shields at the cost of debt (Taggart. depends on the risk of the debt as well as the changes in the level of the debt. Otherwise. Because the risk of a levered firm is a weighted average of the risk of an unlevered firm and the risk of the interest tax shields. then the higher the interest tax shields. risky cash flows can be equivalently valued by using the CCF method with the interest tax shields in the cash flows or by using the FCF method with the interest shields in the discount rate. 21 Feb 2015 04:17:50 AM All use subject to JSTOR Terms and Conditions . when using the FCF method. because the APV method is equivalent to CCF when the interest tax shields are discounted at the cost of assets. unlevering 'Teaching materials include Ruback (1989. The CCF method has been used in teaching materialsto value cash flow forecasts. 1995b) and Holthausen and Zmijewski (1996). the discount rate for the CCFs does not have to be re-estimated every period. the interest tax shields will have the same risk as the firm. In contrast. The APV method is generally calculated as the sum of FCFs discounted by the cost of assets plus interest tax shields discounted at the cost of debt. However. As a result. a tax adjustment has to be made when unlevering an equity beta to calculate an asset beta. The APV method treats the interest tax shields as being less risky than the assets. the value of the firm has to be estimated simultaneously. When debt is a fixed proportion of value. the presence of less risky interest tax shields reduces the risk of the levered firm.andto show its relationto the APVmethod. I showed that the interest tax shields associated with riskless cash flows can either be equivalently treated as increasing cash flows by the interest tax shield. 1974). or as decreasing the discount rate to the after-tax riskless rate. In my paper on riskless cash flows. financetextbookscontainsome of the ideas about the relation between the discount rate for interest tax shields. The CCF method is closely related to my work on valuing riskless cash flows (Ruback.

The NI Path NI includes any tax benefit from debt financing because interest is deducted before computing taxes. then. Since CCFs measure the after-tax cash flows from the enterprise. the CCF method is a simpler approach. including the calculation of the cash flows and the discount rate.2 The cost of equity capital. I. the FCFs to equity are discounted at the cost of equity capital.50.By including cash flows to all security holders. Available cash flow is NI plus cash flow adjustments and non-cash interest. the RI approachdoes not mitigate the valuation issues addressed in this paper. 21 Feb 2015 04:17:50 AM All use subject to JSTOR Terms and Conditions .Ruback* CapitalCash Flows 87 formulas. as Lundholm and O'Keefe (2001) stress. like the WACC. This section details the calculation of the CCFs in subsection A and explains the calculations of KA in subsection B. Although the focus of this paper is on cash flow methods that yield estimates of total enterprise value. with a more general proof. Section I describes the mechanics of the CCF method. Calculating Capital Cash Flows CCFs include all of the cash flows that are paid or could be paid to any capital provider. Figure I summarizes the calculation of CCFs.KA.and financial policy. increase NJ. These non-cash interest payments are deducted from NI like cash interest but are not a cash outflow and. it requires a simultaneous estimation of the equity-to-value ratios and the value whenever the debt is forecasted in levels. I also show thatthe assumption about financial policy has implications regardingthe impact of taxes on risk and.69. A. An example is presented in subsection C. the results have implications for the Equity Cash Flow (ECF) and Residual Income (RI) methods. instead of paying the interest in cash. thereby. 1. That method is equivalent to the FCF method and has the same drawbacks. In those situations. Cash flow adjustments include those adjustments required to transform the accounting data into cash flow data. the present value of these cash flows equals the value of the enterprise. Section II shows that the CCF method is equivalent to the FCF method through an example and. because these are non-cash subtractions from NI. therefore. CCFs measure all of the after-tax cash generated by the assets. Thus. The calculations depend on whether the cash flow forecasts begin with net income (NI) or earnings before interest and taxes (EBIT). Section III relates the CCF and the AP V methods and shows that the difference between the two methods depends on the implicit assumptionaboutthe financialpolicy of the firm. This content downloaded from 146. must be 2See Ruback (1995b) and Esty (1999) for a discussion of the relation between the FCF and ECF methods. the RI approach is equivalent to the FCF method as long as consistent assumptions are used-including the assumption that the discount rate consistently incorporates the assumed debt policy. In the ECF method. therefore. Mechanics of CapitalCash Flow Valuation The present value of CCFs is calculated by discounting them by the expected asset return. Non-cash interest occurs when the interest is paid in kind by issuing additional debt.Similarly. Typical adjustments include adding depreciation and amortization. The interest tax shields.changes as leverage changes. determinesthe approachused to transformequity betas into asset betas.81 on Sat. Section IV concludes. This paperprovides the basis for the applicationsof CCFs and highlights the linkages between the three methods of cash flow valuation.

have to be added to the FCFs to arrive at the CCFs. The interest tax shields on both cash and non-cash debt are added because both types of interest tax shields reduce taxes and.FCFs equal CCFs less the interest tax shields. therefore. In practice. which is used to compute value using the after-tax WACC (WACC). Capital expenditures are subtractedfrom NI because these cash outflows do not appearon the income statement and. corporatetaxes have to be estimated to calculate earningsbefore interest and aftertaxes (EBIAT). thereby. EBIAT plus cash flow adjustments equals FCF.instead of NI. CCF is computed by adding cash interest to available cash flow so that cash flows representthe after-tax cash available to all cash providers. Interesttax shields.50.81 on Sat. are not deducted from NI. thus. The label "available cash flow" often appears in projections and measures the funds available for debt repayments or other corporate uses. increase after-tax cash flow. which should include any special This content downloaded from 146. Typically the taxes are estimated by multiplying EBIT by a historical marginaltax rate. Calculating Capital Cash Flows Flowbegin NI Cash Flow Adjustments EBIT Estimate of Corporate Tax S Depreciation Amortization SAdd Non-Cash Interest Capital Expenditures Change in Working Capital Deferred Taxes EBIAT Available Cash Flow Cash Flow Adjustments AddCash Interest FreeCashFlow Capital Cash Flow Add Interest Tax Shields added to NI to calculate cash flow available. The EBIT path should yield the same CCFs as the NI path. EBIAT is then adjustedusing the cash flow adjustments that transform the accounting data into cash flow data. the NI path is usually easier and more accuratethan the EBITpath. 21 Feb 2015 04:17:50 AM All use subject to JSTOR Terms and Conditions . Subtracting the increases in working capital transformsthe recognized accounting revenues and costs into cash revenues and costs. however. The EBITPath When cash flow forecasts present EBIT.69. The primaryadvantageof the NI path is that it uses the corporate forecast of taxes.FinancialManagement* Summer2002 88 Figure i. 2.

81 on Sat.R. B. If expected returns in equation (1) are determined by the Capital Asset Pricing Model (CAPM): KD = RF + /DRp (2) KE = RF + IEERP (3) where R. Using the pre-tax WACCas a discount rate is correct. R. equity-to-valueratios are not in equation(7).Ruback* CapitalCash Flows 89 circumstancesof the firm. Calculating the Expected Asset Return The appropriatediscount rate to value CCFs is a before-tax rate because the tax benefits of debt financing are included in the CCFs. is the risk premium. This means that the debt-tovalue and equity-to-valueratios do not have to be estimatedto use the CCF valuationmethod. and 3D and PE are the debt and equity betas. the riskpremium. P. The EBIT path involves estimating taxes. E/V is the equity-to-value ratio.50.R . The debt-to-valueand PU. 21 Feb 2015 04:17:50 AM All use subject to JSTOR Terms and Conditions .. pU. This ignores the special circumstances of the firm and adds a likely source of error. usually by assuming a constant average tax rate. andon the unleveredasset beta.does not dependon capitalstructure and does not have to be recomputedas capital structurechanges. KA. therefore. The pre-tax rate should correspond to the riskiness of the CCFs. This eliminatesmuch of the complexity encounteredwhen applyingthe FCF method. but there is a much simpler approach. respectively.69. KA: KA = Pre-taxWACC = RF +# uRp (7) Note thatthe pre-taxexpectedasset returndependsonly on the market-wideparametersfor the risk-freerate. estimate the asset beta. is a weighted average of the debt and equity beta: D Pu= V E + PE V (6) Substituting equation (6) into equation (5) provides a simple formula for the pre-tax WACC which is also labeled as the Expected Asset Return. Taxes are rarelyequal to the marginaltax rate times taxable income. Substituting equations (2) and (3) into equation (1) yields: Pre-taxWACC = D E V(RF + iDRP)+ V(RF +#ERP) (4) Simplifying: Pre-tax WACC= RF + K D +V fEE Rp (5) The beta of the assets.It takes two steps. and KD and KE are the respective expected debt and equity returns. One such discount rate is the pre-tax WACC: Pre-tax WACC = D + E VKD VKE (1) where D/V is the debt-to-value ratio. First.The asset beta is usually estimated using This content downloaded from 146. The discount rate for the CCFs is simple to calculate regardless of the capital structure. is the risk-free rate.

000 to be depreciatedequally over three years.25 = 1.000 at the beginning of year one. an asset beta of 1. which is reduced by the hypothetical taxes on EBIT to determine EBIAT.0 X 8%= 18%. As Panel B of Table I shows. and $20. I demonstratethis equivalency in subsection A by extending the numerical example of Table I and showing that the FCF valuation is the same as the CCF valuation.30 in the second year. Second. C. use Pu. II. Because the two methods are equivalent. 21 Feb 2015 04:17:50 AM All use subject to JSTOR Terms and Conditions .50. if the equity beta is 1. The project is financed with debt so that the initial debt is $100.CCF is calculatedby addingthe expectedinterestto the cash flow available. by the equity-to-value ratio and adding an estimate of the debt beta multiplied by the debt-to-value ratio. The CCF is calculatedby following the NI path. together with the risk-free rate. the expected asset returnis 10%+ 1. The asset beta is assumed to equal 1. The Relation Between Capital Cash Flow and Free Cash Flow Valuation The FCF and CCF methods are equivalent.3 The forecasted expected pre-tax operating profits are $50. The debt is assumed to be risky.25.0.996. The example assumes an initial investment of $100. R.KA. and the risk premium.25 + 0.Using a risk-free rate of 10%. The after-tax cost of debt depends on the assumed riskiness of the debt with the cost of debt calculated as its CAPM expected return using equation (2). The FCFs are valued using the after-tax WACC.75 X 1.75. The levered cost of equity is calculated by levering the asset beta to 3The equivalency of the CCF and FCF methods does not depend on a constant asset beta. and 0. Numerical Example Table I contains a numerical example that demonstrates the CCF method.25 X 0.. The asset beta could change each year. discounting the CCFs at the expected asset returnresults in a value of $136. The FCFs are calculated from EBIT. thus. Panel A details the assumptions. is assumed to be constant unless the asset composition changes. The asset return does not depend on leverage because it is a pre-tax cost of capital. Subsection B presents a more general proof of the equivalence of the CCF and FCF methods. The cash flow available is equal to NI plus noncashadjustments. $50. the risk premium is assumed to be 8%. the debt beta is 0.81 on Sat.25. The easiest way to calculate the asset returnis to use the asset beta in the CAPM. For example. and the tax rate is assumed to be 33%. Subsection C presents some suggestions on choosing between the methods. The value of the CCFs is calculated using the expected asset return.000 in year two.Adding the non-cash adjustmentsto EBIAT results in FCFs. to compute the expected asset return.000 in year one.0.0 in all three years. With an asset beta of 1.35 in the first year. an assumed risk free rate of 10%.000 at the beginning of year three. the choice between them is governed by the ease of use. and an assumed risk premiumof 8%. 13. This content downloaded from 146. and $70.FinancialManagement* Summer2002 90 equation (6) by multiplying the equity beta.000 at the beginning of year two. $60. In practice. It remains constant even though the leverage changes through time.25 in the thirdyear.000 in year three. then the asset beta is 0. and the equity-to-value ratio is 0. however.0.69. R. with a debt beta of 0. A. The WACChas two components:the aftertax cost of debt and the levered cost of equity. 0. The risk-free rate is assumed to be 10%. and a risk premium of 8% yields an expected asset returnof 18%. the asset beta is related to the assets of the company and. Numerical Example Panel C of Table I presents a FCF valuation of the same cash flows valued using CCFs in Panel B.

bNoncash adjustments include depreciation plus $10.30 1.000 33.76.81 on Sat.333 45.046 66. Using the CAPMandthe 4This formula is derived in Section III.8475 6.267 11.7182 2.400 68.292 20. 5See Esty (1999) an explanation of the iterative technique and a project finance application of that approach.754 13. the implied equity beta is 2.046 50.69.333 16.000 33.924 60.308 22.200 63.246 18. that value can be used to compute the debt and equity proportions.200 20.692 18.4Generally.25 50.000 Panel B.00 0.333 36.924 57.0% 0.000 70. Based on the implied equity-to-value ratio of 27.0% in the first year.00 0.766 136.50. determine the levered equity beta.667 12.292 Plus: Expected Interesta Capital Cash Flow Cost of Assetsc Discount Factor Present Value of CCFs Total Enterprise Value 12.800 58.276 2.808 Interestis calculatedusingthe ExpectedCostof Debt fromthe CAPM(riskfreerateplus the debtbeta aExpected times the risk premium).6086 49. the asset beta of 1. and the debt beta of 0. An Example of Capital Cash Flow and Free Cash Flow Panel A.867 1. Assumptions Market Parameters: Riskless Debt Rate = 10% Risk Premium = 8% Tax Rate = 33% Asset Beta Debt Beta Expected Cash Flows: Operating Profit Less: Depreciation EBIT Less: Expected Interesta Pre-Tax Income Less: Taxes Net Income Non-Cash Adjustmentsb Cash Flow Available Beginning Debt Year 1 Year2 Year3 1.467 6.724 18.B of this paper.959 43.0.667 6.591 43.5 However.996 45.667 2. 21 Feb 2015 04:17:50 AM All use subject to JSTOR Terms and Conditions .713 43.333 57. cExpectedasset returnis calculated using the assumed asset beta in the CAPM with the assumed riskless debt rate and risk premium.000 of other adjustments. an iterative or dynamic programmingapproachis used to solve for a consistent estimate of enterprise value.800 3.35.000 100.400 34. The formula for levering the asset or unlevered beta is: PE VD E (8) which requires information on the value of the firm to compute the percentage of debt and equity in the capital structure. the WACCand its components need to be recomputed each year. because the value is already computed in Panel B. Capital Cash Flow Valuation CashFlow Available 45.000 33.333 26.35 1.422 41.00 0.Ruback* CapitalCash Flows 91 Table I. Because the fraction of debt is not the same each year.0% 0.333 66.0% 0. This content downloaded from 146.

Weighting the expected after-tax cost of debt and the expected cost of equity by their proportionsin the capital structureresults in a WACCof 14.426 136.996 12. determiningthe debt and equity proportions.66 65.6431 43.1% 8. Repeating the process of valuing the enterprise.000 of other adjustments. The capital structurechanges in each period.0% for the second year and 16.0% 2. results in a WACC of 16.167 43.and the corresponding amount of the interest tax shields.000 58.000 34. These after-tax WACCsrise as the percentage of debt in the capital structure.200 36.665 Percent Equity Contribution' WACC DiscountFactor PresentValueof FCFs TotalEnterpriseValue bNoncash adjustments include depreciation plus $10.3% 21.667 12.667 5.800 17.8% Percent EquityBetag 27. and the amount of debt outstanding does not remain constant throughout the life of the project.1% 23. TotalEnterpriseValue (TEV)is calculatedby discountingthe FCFs by the after-tax WACCs.4% Capitalization: TotalEnterpriseValued Debt WACCCalculations: Debt 73. This content downloaded from 146.0% 16.996 100.996.6% 1. assumed marketparameters.0% 2.69. gEquityis determined by levering the asset beta ((asset beta .567 43.333 54. exactly the same value as obtained in the CCF calculations in Panel B of Table I.76 51.333 61. and estimating the equity cost of capital according to the CAPM.900 136. Free Cash Flow Valuation EBIT Less:Tax on EBIT EBIAT Non-CashAdjustmentsb FreeCashFlows Year 1 Year2 Year3 16.debt beta contribution)/percentequity). unlevering the asset beta.9% for the first year. hCost of equity is calculated using the CAPM as the riskfree rate plus the equity beta times the risk premium.333 67.50. the discount rate for each period is the compounded rate thatuses the preceding after-tax WACCs.81 on Sat.1% in the first year. dTotalEnterpriseValue is the present value of the remaining cash flows. Since the after-tax WACCschange.3% 4.9% 16. 'Equity contribution is the cost of equity times the percent equity.6% for the third year.214 20. eAfter-tax cost of debt is the Expected Cost of Debt times (1-tax rate).3% 8.6% 0.867 43.6% 8.932 50. An Example of Capital Cash Flow and Free Cash Flow (Continued) Panel C. 'Debt contribution is the After-tax Expected Cost of Debt times the percent debt.500 11.0% 0.7% 14.9% 0.500 26.7501 45.the expected cost of equity is 32.100 24.667 8.The resultingvalue of the FCFs is $136.Financial Management * Summer 2002 92 Table I.0% 48.0% Contributionf 6.4% 1.8702 47.6% After-Tax Coste 8. because the ratio of the value of the remaining cash flows. 21 Feb 2015 04:17:50 AM All use subject to JSTOR Terms and Conditions .39 Costh 32.905 13.000 102. fall.

Value is calculated using the CCF method.50.respectively. KD. By substitutingthe equalitybetween the pre-taxWACCand the cost of assets from equation(7): FCF VFCF = (R. 1) KD(1is the after-taxexpected cost of debt. and KE is the expected cost of equity.is defined as: D E WACC= .Ruback* CapitalCash Flows 93 B. times the interest rate on the debt. capital expenditures.KD(1-r)+ KE V V (10) with D and E equal to the marketvalue of debt and equity. then CCF is equal to FCF plus interest tax shields: CCF = FCF + InterestTaxShield = FCF + ZKD (11) where KDD is the interest tax shield calculated as the tax rate.rKD D V This content downloaded from 146. By combining equations (9) and (10): VFCF = D FCF C E (13) KD V -)+ -V KE _(1 In equation(13). VcCF. WACC. This cash flow is before tax. which measures the cash flow of the firm if it were all equity financed. To keep the analysis simple. VFCF'. and changes in working capital.the after-tax WACC. RK where RF is the risk-free rate and the risk premium.Since FCF measures the cash flow assuming a hypothetical all equity capital structure. r. including any benefits of interest tax shields from its financial structure. RPis The goal is to show that the value obtained using FCFs and WACCis the same as the value obtained using CCFs and KA. times the amount of debt outstanding.69. ris the tax rate.by discounting the CCFs by the expected return on assets. Proof of Equivalency This section shows that the CCF method is equivalent to the FCF method. but after cash adjustments such as depreciation. The expected asset return is measured using the Capital Asset Pricing Model (CAPM) and the asset beta (f8) of the project being valued: FCF + rKDD (12) VCCF= RF + f. In other words. is calculated using the FCF method by discounting the FCFs by the after-taxWACC: FCF (9) VFCF -WACC where V is the value of the project being valued.81 on Sat. the goal is to show that equation (9) is identical to equation (12). + fpRp)-pKgD D V - FCF KA . The CCF is the expected cash flow to all capital providers with its projected financing policy. The after-tax operating cash flow equals earnings before interest and after-tax plus the cash flow adjustmentsand equals FCF. D. The value. KE and KD are measuredusing the CAPMaccordingto equations(2) and (3). 21 Feb 2015 04:17:50 AM All use subject to JSTOR Terms and Conditions (14) . assume the asset being valued generates a constant pre-tax operating cash flow.

'Taggart (1991) analyzes the impact of personal taxes on the FCF approach and shows that the corporate tax rate is the only tax rate that explicitly enters the valuation equation. Because that target structure does not (by assumption) change over time. the FCF method is easier than the CCF method. Also. in most transactions. Choosing Between Capital Cash Flows and Free Cash Flow Methods The proof in subsection II.A and Panel C of Table I. Thus. the CCF method will be the easier to apply. In the simplest valuation exercise. the CCF method is generally the more direct valuation approach. applying the FCF method is more complex and more prone to errorbecause.69. restructurings. The ease of use. capital structure. the FCF method is usually the best approach. These cash flows are valued by discounting them at the expected cost of assets.B shows that the CCF method and the FCF method are equivalent because they make the same assumptions about cash flows. and taxes. Therefore. Because such plans typically include the forecasted interest payments and NI. Nevertheless. firm and the equity values have to be inferred to apply the FCF method. When applied correctly using the same information and assumptions. When the goal is to get a simplified 'back-of-the-envelope' value. To apply the FCF method. as illustrated in subsection II. When the cash flow projections include detailed informationabout the financing plan. this proof shows that the FCF approachin equation (9) and the CCF approach of equation (12) will. is determined by the complexity of applying the method and the likelihood of error. The algebraic equivalence of the CCF and FCF implies that the corporate tax rate is also the only tax rate in the CCF valuation equation. the CCFs are simply computed by adding the interest payments to the NI and making the appropriatenon-cash adjustments. is governed by ease of use. 21 Feb 2015 04:17:50 AM All use subject to JSTOR Terms and Conditions .FinancialManagement* Summer2002 94 Multiplying both sides by the denominator on the right-hand-side of equation (14) yields: VFCF(KA). of course. and bankruptcies. result in identical present values for risky cash flows. the two methods provide identical answers.50.KDD = FCF (15) Rearrangingterms by adding zKDD to both sides and dividing by the cost of assets shows that: VFCF FCF+KDD - VCCF (16) which is identical to equation (12). therefore.81 on Sat. This content downloaded from 146. The choice between the two methods. the discount rate can be calculated in a straightforward manner using prevailing capital market data and information on the target capital structure. when correctly applied. The form of the cash flow projections generally dictates the choice of method. affect the FCF and CCF value. a single WACC can be used to value the cash flows. This type of valuation often occurs in the early stages of a project valuation before the detailed financial plan is developed. In contrast.6 C. leverage buyouts. the CCF method can easily incorporatecomplex tax situations. This process is simple and straightforwardeven if the capital structurechanges through time. personal taxes may affect the expected debt and equity returns and. thereby. when the cash flows do not include the interest tax shields and the financing strategy is specified as broad ratios.

locating it in the middlecolumn of TableII. CapitalCash Flows and Adjusted Present Value Both CCF and APV methods can be expressed as: Value= Free Cash Flows Discounted at KA + Interest Tax Shields Discounted at KITs where KITS is the discount rate for interest tax shields. I define the value of the interest tax shields in the CCF valuation as a proportion. This implies that the appropriate discount rate is the cost of assets.TableII calculates the difference in values assuming perpetual cash flows and interest tax shields. In this example.Ruback* CapitalCash Flows 95 Ill. the APV method generally uses the debt rate and the CCF method uses the cost of assets. When debt is assumed proportionalto value.Forexample. This implies that the appropriatediscount rate for the interest tax shields is the debt rate. then the ratio of the expected asset returnto the expected debt return is 1.The methods differ in KITs. locating it in the middle row of Table II. then the value of the interest tax shield is about 15%of the all equity value. 21 Feb 2015 04:17:50 AM All use subject to JSTOR Terms and Conditions . This content downloaded from 146.5. In the CAPM framework. KA. therefore.50. the discount rate for the interest tax shields should depend on the beta of the interest tax shields: KITS = Risk free rate+ PITS * Risk Premium (18) When debt is assumed fixed.81 on Sat. It also implies that taxes have no effect on the transformationof equity betas into asset betas. if KD =10% and KA =15%. y. which is the rate used in the CCF method. This occurs because they infer the equity costs that result in equivalence in their FCF valuations instead of obtaining discount rates from the CAPM. It also implies that the interest tax shields reduce risk so that a tax effect should appear when unlevering equity betas. which is generally computed using the CAPMwith the the discount rate for interesttax shields: beta of an unlevered firm.69. The ratio of VAPV to V becomes: ccF 1+ VAP VCCF KA KD (17) 1+y TableII presentsthe percentagedifferencesbetweentheAPVandCCFvaluations. the discount rate for the FCFs is the cost of assets.7 To gauge how much higherAPV valuationsarerelative to CCF valuations. subsection B shows that the beta of the interest tax shields is equal to the unlevered or asset beta. Debt could also be a linearfunctionof firm value with both fixed andproportionalcomponents. which is the rate used in the APV method.the APV approachwould provide a discountedcash flow value that is 7% higher than the CCF value. If the tax rateis 36%andthe debt is 42%of the all equity value. of the all equity value. KA.APV assigns a higher value to the interest tax shields so that values calculated with APV will be higher than CCF valuations.Subsection C shows that the beta of the interest tax shields with a linear debt policy is a value-weighted average of the interest tax shield betas for the fixed and proportionaldebt policies described 7Inselbagand Kaufold (1997) present examples of FCF and APV valuations that result in identical values for debt policies with both fixed debt and proportionaldebt. For both methods. subsection A shows that the beta of the interest tax shields equals the beta of the debt.

bAll Equity Value is the FCFs discounted at the cost of assets.t where K is the fixed yield on the debt. then the interest tax shields will also be riskless. DKo (20) VDK.t By substituting equation (20) into equation (19)..81 on Sat. therefore. PITs.9If the debt is assumed to be riskless.69. The value of the debt can change throughtime if KD is fixed and the cost of debt changes. RM ) Vrs. equal to the beta of the debt when the debt is assumed to be a fixed dollar amount.tis the cost of debt in period t from equation (2).Percentage Differences Between APV Values and CCFValues Tax Shield/All EquityValueb (VApvVCCF) Ratioof ExpectedAsset Returnto DebtRate(KA/KD)a 1. equals: IrS = Cov(VITs. then the interest tax shields will This content downloaded from 146. Fixed Debt Policy When debt is perpetual and fixed as a dollar amount.. be expressed as: VITS. D. Assuming KD is the fixed yield. Cov(VD. If the debt is risky. and zis the tax rate.25 1. A.t-Var(R ) (22) By substituting equation (21) into equation (22) and simplifying.t .50 1. the value of the interest tax shield at time t can.8.FinancialManagemento Summer2002 96 Table II. in subsections A and B. 21 Feb 2015 04:17:50 AM All use subject to JSTOR Terms and Conditions . which does not change as the value of the firm changes.t= ZVD. then the value of the interest tax shields is: VITSt = (19) KD. RM) (23) = CVVar(RM ) TheVDIs beta of the interest tax shields is.t (21) The beta of the interest tax shields. therefore.75 10% 2% 5% 7% 15% 20% 3% 4% 7% 8% 10% 13% "Calculationsassume perpetual cash flows and interest tax shields. respectively.50. KD.K KD.

69. This content downloaded from 146. the analysis assumes strictly proportionaltaxes. By setting equation (26) equal to equation (27): E VL D +-/=D VL D = PL=U-rD-(/U-D) VL (28) which can be simplified as: E= D E (29) u-D))/E flu--(flD+T Thus. The assumption of fixed debt and the result that the beta of interest tax shields equals the debt beta implies that leverage reduces the systematic risk of the levered assets. by value of the interest tax shields from the debt of the levered firm.81 on Sat.50. The value of a levered firm. 9If the debt is not principal. VL. This result shows that the practice of discounting interest tax shields by the expected return on the debt is appropriatewhen the debt is assumed to be a fixed dollar amount. he eqihty beta is equal to)theasset beta less the proportion of debt borne by the debt holder and the reduction due to the tax effect and scaled by leverage. 3E is the equity beta and PD is the debt beta.exceeds the value of an unlevered or all equity firm. equation (25) simplifies to: a =f V(llU (26) -. Pu. because the government absorbs some of the risk of the cash 8Whendebt is assumed to be fixed in value instead of a fixed dollar amount. I assume that interestis deductibleand that interesttax shields are realized when interestis paid. Also.VL + VL iD (27) Where E is the equity of the levered firm. The equity beta is reduced by the tax effect. then the beta of the interest tax shields would equal the beta of the debt when the interest payment and principle payments have the same beta. PL' is a value-weighted average of the unlevered beta.then the beta of the interesttax shields is zero regardless of the debt beta. 21 Feb 2015 04:17:50 AM All use subject to JSTOR Terms and Conditions . P TS: V(25) L When the beta of the interest tax shields equals the debt beta.rD) The beta of a levered firm. and the beta of the interest tax shields. L. VITS: VL= VU + VITS (24) Equation (24) holds in each time period and abstracts from differences between levered and unlevered firms other than taxes.'can also be expressed as a value weighted average of the debt and equity of the levered firm: = E D #E )L.Ruback* CapitalCash Flows 97 have the same amount of systematic risk as the debt. The beta of the levered firm. Vu.

With fixed debt. ) Vu.Var(RM) -= (33) u The equality between the beta of the interest tax shields and the beta of the unlevered firm implies that the rate used to discount the interest tax shields is equal to KA. the firm varies the amount of debt outstanding in each period so that: VD= 6v. the beta of a levered firm is a weighted averageof the beta of the unleveredfirm and the beta of the interesttax shields. the unlevered or asset cost of capital. The value Vu of the interest tax shields is the tax rate times the value of the debt so that: = = VIrs zVD rdV. (31) where Sis the proportionalitycoefficient and is the value of the unlevered firm.t fiTS =- _ VITSt-lVar(RM ) Cov(rVu. 21 Feb 2015 04:17:50 AM All use subject to JSTOR Terms and Conditions . the interest tax shields portion of the cash flows are insulated from fluctuations in the marketvalue of the firm.t-.In the next subsection. Fromequation(25). taxes do not appearin the unleveringformula. (32) By substitutingequation (32) into the definition of the beta of the interest tax shields from equation(22): . RM ) TZ'Vu. Therefore. This content downloaded from 146. Since the asset beta equals the interest tax shield beta.' The equalitybetween the betas for the interesttax shields and the assets also implies thatthere is no levering/unleveringtax effect.81 on Sat. B.equation(29) simplifies to: _ E+D(1-)30 E Equation(30) is the standardunleveringformulathatcorrectlyincludestax effects whenthe debtis assumedto be fixed and assumesa zero debtbeta. When the debt is riskless. the beta of the levered firm equals the beta of the 'OHarrisand Pringle (1985) also show that the interest tax shields should be discounted by the pre-tax weighted average cost of capital when debt is assumed to be proportionalto value. RM.50.69.. Proportional Debt Policy When the value of debt is assumed to be proportional to total enterprise value. the beta of the debt is zero.R ) Cov(VITs.I show thatwhen debtis assumedto be proportionalto firm value.98 FinancialManagement* Summer2002 flows.t-iVarRg Cov(Vur .

It is not obvious from the forecasts themselves whether the assumption of proportional debt or fixed debt is the better description of debt policy. the proportional policy seems more accurate. Nevertheless.If debt policy adheres to the forecasts regardless of the evolution of value through time." C. 21 Feb 2015 04:17:50 AM All use subject to JSTOR Terms and Conditions . Correcting this error does not meaningfully change the results of Kaplan and Ruback (1995).be morecomplexthaneitheranexclusively fixed debtorproportional debt policy.69. if debt is likely to increase as the firm expands and value increases.Luehrman(1997) presentsan example of APV valuation in which debt is assumed to be a constant fraction of book value. Choosing Between Capital Cash Flows and Adjusted Present Value Methods Subsection B shows that the difference between the CCF and the APV methods is the implicit assumptionabout the determinantsof leverage. thereby. For example. That suggests that the CCF approach is more appropriate than the APV approach when valuing corporations. the forecasts typically are characterizedas a changing dollar amount of debt in each year. valuationdependson thatpolicy. a fraction of book value is a fixed dollar amount. CCF (and equivalentlyFCF) assumes that debt is proportionalto value. and that the range around the target is tighter for larger firms. of course. Debt policy can. such as industrial revenue bonds thatare fixed in dollaramounts. Graham and Harvey (2001) report that about 80% of firms have some form of target debt-to-value ratio. To calculatethe beta of levered equity.Rubacko CapitalCash Flows 99 unleveredfirm. the option component of risky debt increases. valuations are often performed on forecasts that make assumptions about debt policy. The answer in these circumstancesdepends on the likely dynamic behavior. Debt cannot literally be strictly proportionalto value at all levels of firm value.50. Alternatively. These cases typically involve some tax or regulatory restriction on debt.81 on Sat. the fixed assumption is probably better. There are circumstances when the fixed debt assumption is more accurate. "Kaplan and Ruback (1995) incorrectly uses tax adjustments to unlever observed equity betas to obtain asset betas when applying the CCF method. whateverthe debtpolicy. be characterizedas a changing percentage of value or as a changing dollar amount through time. distorting the proportionality. when a firm is in financial distress. however. When that policy is characterizedas a targetdebt-to-value ratio. To the extent that book value does not respond to market forces. This content downloaded from 146. For example. These amounts can.equation(29) can be restatedas: iE u -D E / (34) This resultmeansthattax termsshouldnot be includewhen applyingthe CCF or FCF methods. In project finance or leveraged buyout situations. In practice. APV assumes that debt is fixed and independent of value. of course. debtpolicy can include a fixed componentand a componentthat is proportionalto value: VD=VF+ UVU (35) Such a linear debt policy could occur in a project finance application where a fixed amountof debt is subsidized or guaranteedby a government agency and the remaining debt is roughly proportional to the value of the project. then the proportional assumption is probably better.

and KITs calculated using the CAPMwith PrTS from equation (37). the interest tax shields will have the same risk as the value of the firm.81 on Sat. Equation (38) is consistent with the generally accepted approach of identifying project cash flows with different risk characteristics and valuing those components at an expected returnthat reflects their risk. The beta of the interesttax shieldsfor the lineardebtpolicy. VCCF= KA rKDDF + KD (38) where D.t-1Var(RM Cov(rVFt +5Vut.t-1Var(RM) + D VF-P VD. respectively. for example. therefore.50. the value This content downloaded from 146. The discount rate for the interest tax shields from the proportionaldebt is the expected asset return for the same reasons it is the correct rate for the proportionalinterest tax shields discussed in subsection B. In Gilson. for example. the interest tax shields are also fixed.1 VD. The discount rate for the interest tax shields from the fixed portion is the expected debt rate for the same reason that it is the correct rate for the fixed interest tax shields in discussed in subsection A.FinancialManagement* Summer2002 100 The valuationof cash flows from a projectwith a lineardebt policy such as equation(35) will combine features of the fixed debt and proportionaldebt policies. interest tax shields are proportional to the value of the debt so that when debt is proportional to value. 21 Feb 2015 04:17:50 AM All use subject to JSTOR Terms and Conditions . The fixed interest tax shields. In short. #ITS ) WVD.is a value-weightedaverageof the betawith a fixed debt policy (equation23) and the beta with a proportionaldebt policy (equation 33) with the value-weightsequal to the relative values of the fixed and proportionaldebt components: RRM) Cov(WD.69. Hotchkiss. The second term on the right-hand side of equation (38) is the value of the interest tax shields associated with the fixed portion of the linear debt policy. The first term on the right-hand-side of equation (38) is the formula for the CCF value when the debt is proportionalto value (equation 16).t'-1 PA (36) The value of a project with a linear capital structurecould be valued by valuing the interest tax shields using the pre-tax expected return implied by the beta of the interest tax shields from equation (36) and adding that value to the value of the FCFs: FCF VAPV K TKDD KITS is where D is the amount of debt including the fixed and proportionalcomponent.t. and DF are the amount of proportionaldebt and fixed debt. and Ruback (2000).RM) fl/D. When the amountof debt is fixed. and the value of the interest tax shields will vary as the value of the debt varies. The value of the project can also be valued more simply by adding the value of the fixed interest tax shields to the CCF value: FCF + rKDD. will have the same risk as the fixed debt.

at least at its initial stage. and the cost of capital changes as the amount of debt changes. 1983) model the debt policy as mixed throughtime with fixed debt in the first period and proportional debt in subsequent periods. the valuation. because the level of debt is implicitly assumed to be a fixed dollar amount.81 on Sat. APV is generally calculated as the sum of operating cash flows discounted by the cost of assets plus interest tax shields discounted at the cost of debt. The discount rate is the same expected return on assets that is used in the before-tax valuation. The different risk characteristicsof the interest tax shields in equation (38) arise because of the combination of fixed and proportionaldebt in the linear debt policy. Miles and Ezzell (1980. in turn. the CCF method is substantially easier to apply and. because it treats the interest tax shields as being less risky than the firm as a whole. The APV method results in a higher value than the CCF method. For example. The CCF method is simple and intuitive. Because the benefit of tax deductible interest is included in the cash flows. taxes need to be inferred. in the static tradeoff between tax benefits and bankruptcycosts. The after-tax CCFs arejust the before-tax cash flows to both debt and equity. The practical alternatives may be to simply choose between APV approach with its assumed fixed debt policy and the CCF (or equivalent FCF) approach with its assumed proportional debt policy. theoriesof debt policy generallysuggest thatdebt changes as value changes.Ruback* CapitalCash Flows 101 of firms emerging from bankruptcyare valued as the CCF value of theircontinuing operations plus the value of their fixed net operating losses discounted at a debt rate.69. Thus. which. As an example. IV. and then appropriatelyvalue resulting interest tax shields using the corresponding discount rate.But in many instances.That means thatthe CCF or the equivalentFCF methodof valuationwill generallybe preferredto APV and that asset beta calculations should not include tax adjustments. doubling the operations of a firm would double its value.50. and the cost of assets does not generally change through time even when the amount of debt changes. the discount rate does not change when leverage changes. The best approach to estimating the value of interest tax shields is to model the debt policy. 21 Feb 2015 04:17:50 AM All use subject to JSTOR Terms and Conditions .doublesthe tax benefits of debt financingand bankruptcy costs so thatthe amountof debt would also double.Conclusions This paper presents the Capital Cash Flow (CCF) method of valuing risky cash flows. Similarly. reduced by taxes including interest tax shields. The interest tax shields that are discounted by the cost of debt in the APV method are discounted by the cost of assets in the CCF method. Beyond the GrahamandHarvey(2001) evidence thatmost corporationshave targetdebt ratio. is less prone to error. The CCF method is algebraically equivalent to the popular method of discounting FCFs by the after-tax WACC.the proportional debt assumptionappearsto be a more accuratedescriptionof corporatebehavior.however. The cash flow calculations can generally rely on the projected taxes. The CCF method is closely related to the APV method.The ease of use occurs because the CCF method puts the interest tax shields in the cash flows and discounts by a before-tax cost of assets. As a result. a tax adjustmentis made when unlevering This content downloaded from 146. Arzac (1996) recognizes that excess available cash flow is typically used to repay senior debt after a leveraged buyout and suggests a "recursive APV approach"to value the transactions. when applying the FCF method.In most corporatecircumstances. In contrast. as a result. for most applications. will not have the informationto model the debt policy in detail and with precision.

1974.J.R. 114-122.S.J.S."TheValuation Journal ofFinance 50. for example."Valuation Studies 13. interest tax shields are valued at the expected return of debt and taxes do affect the measure of risk." Techniques Large-Scale Esty. this paper makes the more general point that the financial policy affects the choice of valuation technique. 42-49.50. Miles.andM.R.T.S.Ezzell. Finance:Evidencefromthe J. A Note. andHowto ChooseBetweenThem.J.." Paper. Analysis:Howto AnalyzeAccounting TheWharton SchoolandUniversityof Chicago."JournalofFinance 29."FinancialAnalystsJournal52.1980.1996. TaxShieldValuation: Miles.R. 1-25."Reconciling Lundholm.Hotchkiss. 145-154..S.R."Journal ofFinancial and QuantitativeAnalysis 15.Harvey. fromthe Average-Risk DiscountRates-Extensions Harris. forCapital andInvestment of Corporate Decisions-Implications Financing Myers..andC. In contrast. like the FCF method."TheTheoryandPracticeof Corporate Graham. Whatever the debt policy.1995.Ezzell. matches the risk of the assets. and showing its relation to the APV method. makes the more economically plausible assumption that debt is proportionalto value.andJ."JournalofAppliedCorporate Strategies An Empirical of CashFlow Forecasts: Analysis.Working Datato ValueSecurities.andJ."Valuation JournalofProjectFinance5. Furthermore. andJ. Beyond introducing the CCF method.W. and.C.S.81 on Sat.Pringle.102 FinancialManagement* Summer2002 an equity beta to calculate an asset beta. A proportionaldebt policy."ContemporaryAccountingResearch 18."Journalof Financial Economics60." Kaplan. 187-243. implies that interest tax shields are valued at the cost of assets and that taxes do not affect the measure of risk that goes into calculating the discount rate.S. 719-730. as an example."Journalof Finance40.C. Finance10. the debt policy need not be exclusively proportionalor fixed.andT.andR.andH.2001. The risk of the interest tax shields..R. "UsingAPV:A BetterTool for ValuingOperations. andR. 21 Feb 2015 04:17:50 AM All use subject to JSTOR Terms and Conditions ."HarvardBusiness Review 75.1999. forValuing Projects. 237-244. 43-74. This content downloaded from 146. when the amount of debt is fixed.2000."Security Holthausen. In contrast. Luehrman. 1059-1093."TheWeightedAverageCostof Capital.Ruback.E. CashFlowModel fromtheDiscounted ValueEstimates R.and ProjectLife: A Clarification.1996. Arzac.O'Keefe."Reviewof Financial Gilson. valuation depends on that policy and the challenge is to value the cash flows using an approach that consistently incorporates the assumption about debt policy."Reformulating 1485-1492.J.C.Zmijewski..A.m References of HighlyLeveraged Firms."Improved of Bankrupt Firms. I provide a CCF valuation for a linear debt policy that has both fixed and proportional components.S.1985. 1997.1985.Kaufold. and the ResidualIncomeModel.E."TwoDCFApproaches Financing Companies Inselbag. UnderAlternative forValuing I. demonstrating its conceptual equivalence to the FCF method. the CCF method.N."Interactions Budgeting.69.R.2001. "Risk-Adjusted Case.PerfectCapitalMarkets. 311-335."Journalof Financial Research8. Ruback.B. therefore.E. Field.A.A.1997. andMarket R. 9-25.

8-20.S.R. "ConsistentValuationand Cost of CapitalExpressionswith Corporateand Personal Taxes.S. Case No. Ruback. "Calculating ofFinancial 15.Rubacko CapitalCash Flows 103 the Value Riskless Economics Market of Cash Journal Flows. 1989..S. 1991.A." Ruback."TechnicalNote for Introductionto CashFlow ValuationMethods."TechnicalNote for CapitalCashFlow Valuation. This content downloaded from 146. 1995b. Taggart.50..81 on Sat.. 1995a. Ruback. Ruback. 323-339.R."HarvardBusiness School."HarvardBusiness School. 21 Feb 2015 04:17:50 AM All use subject to JSTOR Terms and Conditions ."HarvardBusiness School. Case No."Financial Management20. CaseNo. 289-057.. 295-155.S.R. 1986. 295-069."TeachingNote for RJRNabisco..69.R.R.