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Valuation of cash flows with constant leverage: Further insights

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  • Ignacio Velez-Pareja
  • Joseph Tham

Abstract

It is widely known that if the leverage is constant over time, then the cost of equity and the Weighted Average Cost of Capital (WACC) for the free cash flow, FCF, is constant over time. In other words, it is inappropriate to use a constant WACCFCF to discount the free cash flow (FCF) if the leverage changes over time and some conditions are not satisfied. However, it is common to find analysts who inconsistently use a constant WACCFCF even if the leverage is not constant and the proper conditions are not satisfied. In this teaching note, we use a simple numerical example to illustrate how to modelcash flows that are consistent with constant leverage. We verify the consistency of the example with two basic principles: conservation of cash flows and conservation of values. The note is based on a previous one and includes the procedure to value with constant leverage when some restrictive conditions are not satisfied.

Suggested Citation

  • Ignacio Velez-Pareja & Joseph Tham, 2007. "Valuation of cash flows with constant leverage: Further insights," Proyecciones Financieras y Valoración 4323, Master Consultores.
    • Handle: RePEc:col:000463:004323
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    More about this item

    Keywords

    WACC; constant leverage; cash flows;
    All these keywords.

    JEL classification:

    • D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • H43 - Public Economics - - Publicly Provided Goods - - - Project Evaluation; Social Discount Rate

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