Two Different Ways of Treating Corporate Cash in FCF Valuations—And the Importance of Getting the Cost of Capital Right

11 Pages Posted: 1 Nov 2017

See all articles by Peter D. Easton

Peter D. Easton

University of Notre Dame - Department of Accountancy

Gregory A. Sommers

Southern Methodist University (SMU) - Accounting Department

Date Written: Summer 2017

Abstract

The methods for calculating free cash flow presented in texts on financial statement analysis and valuation appear to be very different from those in corporate finance texts, causing some confusion among academics as well as practitioners. Financial statement analysis and valuation texts generally begin by valuing just the enterprise operations—that is, the entity that engages in the firm's primary revenue‐generating activities—and then adding back the value of its cash holdings and other financial assets. The corporate finance approach is typically to value all the assets together, including financial assets that are not used in the production of the goods and services provided by the firm. Using a simple example, the authors show that the valuation of the equity ownership of the firm should be the same for both methods of calculating free cash flow, provided the analyst makes the appropriate adjustments to the method for calculating the cost of capital (WACC) used to discount forecasted free cash flows to a present value.

Suggested Citation

Easton, Peter D. and Sommers, Gregory A., Two Different Ways of Treating Corporate Cash in FCF Valuations—And the Importance of Getting the Cost of Capital Right (Summer 2017). Journal of Applied Corporate Finance, Vol. 29, Issue 3, pp. 71-79, 2017, Available at SSRN: https://ssrn.com/abstract=3061276 or http://dx.doi.org/10.1111/jacf.12251

Peter D. Easton (Contact Author)

University of Notre Dame - Department of Accountancy ( email )

Mendoza College of Business
Notre Dame, IN 46556-5646
United States
574-631-6096 (Phone)
574-631-5127 (Fax)

Gregory A. Sommers

Southern Methodist University (SMU) - Accounting Department ( email )

United States
214-768-1188 (Phone)
214-768-4099 (Fax)

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