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Download (.doc) Optimal Capital Structure for Finite Cash Flows (in Spanish)
Text in Spanish
This paper shows how to proceed to find the optimal capital structure y value with period-to-period constant y... more
This paper shows how to proceed to find the optimal capital structure y value with period-to-period constant y variable leverage, when the discount rate for Escudo fiscal is Ke, the cost of levered equity. Numerical procedures y recursive closed-form non-circular expressions for the finite-period y perpetuity cases are presented, which facilitate any kind of implementation including Monte Carlo simulations. In addition, we illustrate the optimizing procedure with Solver for checking purposes.
Optimal Capital Structure for Finite Cash Flows
This one is in English
This paper shows how to proceed to find the optimal capital structure y value with period-to-period constant y... more This paper shows how to proceed to find the optimal capital structure y value with period-to-period constant y variable leverage, when the discount rate for Escudo fiscal is Ke, the cost of levered equity. Numerical procedures y recursive closed-form non-circular expressions for the finite-period y perpetuity cases are presented, which facilitate any kind of implementation including Monte Carlo simulations. In addition, we illustrate the optimizing procedure with Solver for checking purposes.
Trends and Patterns of Energy Consumption in India
Energy has been universally recognized as one of the most important inputs for economic growth and human development.... more Energy has been universally recognized as one of the most important inputs for economic growth and human development. There is a strong two-way relationship between economic development and energy consumption. On one hand, growth of an economy, with its global competitiveness, hinges on the availability of cost-effective and environmentally benign energy sources, and on the other hand, the level of economic development has been observed to be dependent on the energy demand (EIA, 2006). Using trend analysis and regression techniques, the study finds that there is positive relationship between total primary energy consumption to GDP, population, and per capita energy consumption, however a negative relationship do exist between the energy use and the production of the energy resources in case of India. We can summarize that total primary energy use is one of the key components of the GDP. Population is an important factor for the total primary energy consumption and one of the major contributors for the demand of more energy resources. Per capita energy consumption in the economy has a positive relationship with the total energy use and hence it is one of the important factors of the total energy consumption. As evidence from the developing countries more the nation develops economically, the demand for energy resources also increases. Our findings also suggests in the same direction, as increase in GDP, Population, Per capita consumption leads to more demand of energy resources.
Cost of capital when dividends are deductible
Co-Authored with Julián Benavides Franco
When calculating Tax Savings, TS we are confronted with a strange mix of accounting accrual and market value when... more
When calculating Tax Savings, TS we are confronted with a strange mix of accounting accrual and market value when involving TS in the calculation of the Weighted Average Cost of Capital, WACC or the Cost of Equity, Ke. Firms earn the right to TS once they accrue the interest expense and they actually earn the TS when taxes are paid.
Tax savings and the discount rate (y) we use to calculate their value are involved in the calculation of WACC and Ke. Textbook WACC formulation is a very special and unique case that is not typical. Based on previous findings, we derive a general approach to those formulas that take into account any kind of TS related to the financing decision of a firm and any date when the TS is earned. These formulations can be used to introduce any type of externality that creates value through tax savings not captured by neither the cost of debt nor the cost of equity.
In this paper we develop the formulations for Ke, the cost of levered equity and the average cost of capital when dividends or interest on dividends are deductible. This is the case of Brazil.
We show that using the proper formulation the most known valuation methods, i) Firm value with Free Cash Flow and WACC for the FCF; ii) value with the Capital Cash Flow and WACC for the CCF; iii) equity value with the Cash Flow to Equity and Ke, the levered cost of equity plus debt; iv) Adjusted Present Value, APV are consistent and give identical results.
Strategies for Dealing with Uncertainty (Estrategias Ante La Incertidumbre. Slides)
This is a teaching material (slides) accompanying the book in Spanish Decisiones Empresariales bajo Riesgo e... more
This is a teaching material (slides) accompanying the book in Spanish Decisiones Empresariales bajo Riesgo e Incertidumbre (Managerial Decision Making under Risk and Uncertainty). In this material we show how to use strategies from game theory for dealing with uncertainty.
Note: Downloadable document is in Spanish.
EVA(c) Made Simple: Is it Possible?
Co-authored with Joseph Tham
Velez-Pareja and Tham, 2003a, Velez-Pareja and Tham, 2003b and Tham and Velez-Pareja, 2004 showed the matching between... more Velez-Pareja and Tham, 2003a, Velez-Pareja and Tham, 2003b and Tham and Velez-Pareja, 2004 showed the matching between discounted cash flow (DCF) methods and value added methods. They departed from the net operating profit less adjusted taxes NOPLAT and net income when using market values to calculate the weighted average cost of capital (WACC) and the cost of levered equity, Ke. In those previous works they assumed that the proper discount rate for the tax savings is the unlevered cost of equity, Ku. We assume the same discount rate in this paper. The previous procedures implied circularity between the cost of capital and the levered values. In this paper we show that the same firm values can be obtained using the cost of unlevered equity, Ku and the net income and the interest charges. No circularity is found using this procedure.
Back to Basics: Cost of Capital Depends on Free Cash Flow
Published in The IUP Journal of Applied Finance, Vol. 16, No. 1, pp. 27-39, January 2010
Most popular corporate finance literature and practitioners present the Weighted Average Cost of Capital (WACC)... more Most popular corporate finance literature and practitioners present the Weighted Average Cost of Capital (WACC) calculation as independent from the Free Cash Flow (FCF). It is a common practice that practitioners calculate a WACC a priori and use it independently from the firm value (i.e., from FCF). This study shows that FCF affects WACC and that this interrelationship creates circularity, and also how the same can be solved in a very easy way. The two Appendixes of the paper explain the circularity issue and deriving a proper formulation of the cost of equity.
A Step by Step Guide to Construct a Financial Model Without Plugs and Without Circularity for Valuation Purposes
In this teaching note the reader finds a simplified financial model. In reality, financial models are huge and... more
In this teaching note the reader finds a simplified financial model. In reality, financial models are huge and cumbersome. This is a very simplified model compared with what is found in practice.
We present some basic principles for constructing the financial statements needed for valuation. The reader is encouraged to construct the financial statements for herself on a spreadsheet. The relevant financial statements are: the Balance Sheet (BS), the Income statement (IS) and the Cash Budget (CB). The construction of the financial statements starts from policies and/or targets (i.e. accounts receivable policy or target). With these targets or policies we can construct the financial statements.
The first table to be constructed is the table of parameters. This table organizes all of the relevant information. The subsequent tables are linked to the table of parameters via formulas. We construct other supplementary tables that will be used in the construction of the main financial statements. We indicate the formulas that have to be utilized in the construction of the financial model. In the first line and in the first column the reader finds the letters and numbers corresponding to the Excel spreadsheet in order to make it easier the localization and the construction of the formulas. In the last two columns we have written those formulas. Usually they correspond to the year 0 and/or year 1. When necessary, we show the formulas for other years and we indicate it. Shaded cells are for the input data. If the reader wishes to construct the model exactly as we did, she will be able to do that step by step.
The contribution of this work is double: one is to show that we can construct financial statements without the use of plugs and circularity and the second is that we can use a very simple approach to construct cash flows and to value them.
The model shown has two parts. One is the proper financial statements forecast. The second one is a simple cash flow calculation and valuation exercise using the Capital Cash Flow and assuming the risk of the tax savings equal to Ku, the cost of unlevered equity.
The Correct Definition for the Cash Flows to Value a Firm (Free Cash Flow and Cash Flow to Equity) (Spanish Version)
Surprisingly there is a wide range of interpretations on how to calculate the cash flows for valuation purposes. This... more
Surprisingly there is a wide range of interpretations on how to calculate the cash flows for valuation purposes. This ample definition of what the cash flows are is shared by academicians and practitioners. Some of the definitions openly contradict the essential and basic concepts of cash flow and time value of money.
In this note we specify very clearly what has to be included in those cash flows and the reasons why they should be included. The main issue is related to the inclusion or exclusion of some items in the working capital and the current practice to consider that funds that appear in the Balance Sheet (cash and market securities and the like) belong to the free cash flow FCF and the cash flow to equity CFE. In the same line of reasoning, the idea is that cash flows have to be consistent with financial statements. With a hypothetical example we show the implicit financial facts reflected in the financial statements behind the practice of including as cash flow items that appear in the Balance Sheet.
Note: Downloadable document is in Spanish. The English version is available at http://ssrn.com/abstract=597681
Constructing Consistent Financial Planning Models for Valuation
Published in IIMS Journal of Management of Science, Vol. 1, January-June 2010 (Inaugural Issue)
In this work we show a simplified financial planning model. In reality, financial planning models are huge and... more In this work we show a simplified financial planning model. In reality, financial planning models are huge and cumbersome. This is a very simplified model compared with what is found in practice. We present some basic principles for constructing the financial statements needed for valuation. We show in detail all the items of the financial model and show the formulas to be used for constructing the financial planning model. The relevant financial statements are: the Balance Sheet (BS), the Income statement (IS) and the Cash Budget (CB). The construction of the financial statements starts from input data and policies and/or targets (i.e. accounts receivable policy or target). With these targets or policies we can construct the financial statements. The contribution of this work is double: one is to show that we can construct financial statements without the use of plugs and circularity and the second is that we can use a very simple approach to construct cash flows and to value them. The model shown has two parts. One is the proper financial statements forecast. The second one is a simple cash flow calculation and valuation exercise using the Capital Cash Flow and assuming the risk of the tax savings equal to Ku, the cost of unlevered equity.
Use of Inflation as the Basis to Estimate Nominal Increases in Prices
When estimating future or pro forma financial statements and free cash flows we need to estimate future prices. In... more
When estimating future or pro forma financial statements and free cash flows we need to estimate future prices. In doing this we must estimate nominal increases in prices of many items, for instance selling prices, inputs prices (raw material, labor, overhead, etc.), cost of future debt, and others. If we set nominal price increases without a proper link to inflation we might end up with price increases independent of the inflation rate. The purpose of this teaching note is to present an approach to estimate nominal price increases examining historical nominal prices and inflation rates. This way we can "discover" which policy, if any, the decision maker used to fix prices assuming that she has a fair estimate of immediate future inflation rate.
This approach can be used to asses the risk premium a debt holder (in case it is a bank loan) is applying to the cost of debt. This way we could estimate the cost of future debt, given an estimation of future inflation rate.
We present an appendix where the formal assumptions that has to be met for robust econometric analysis.
Return to Basics: Cost of Capital Depends on Free Cash Flows (In Spanish)
Most popular corporate finance textbooks and practitioners present the Weighted Average Cost of Capital WACC... more
Most popular corporate finance textbooks and practitioners present the Weighted Average Cost of Capital WACC calculation as independent from the Free Cash Flow.
It is a common use that practitioners calculate a WACC a priori and use it independently from the firm value (this is, from FCF). In this note we show that FCF affects WACC and that this interrelationship creates circularity, but we show how it can be solved in a very easy way.
There are two appendixes: one explaining the circularity issue and another one for deriving the proper formulation of the cost of equity.
Note: Downloadable document is in Spanish.
Looking Forward Financial Ratio and Value Analysis (Valor de la firma y razones financieras para el análisis financiero)
Usually financial textbooks present the financial ratio analysis. Many courses are taught in financial analysis and... more
Usually financial textbooks present the financial ratio analysis. Many courses are taught in financial analysis and teachers spend lot of efforts teaching how to calculate financial ratios. Most of them are used to analyze historical financial statements. These analyses are very useful in identifying historical policies and targets. It is useful to analyze a posteriori, the consequences of a given decision and in general the performance of the firm management. Also, they can be used as predictors of the performance of a firm using the proper discriminant analysis technique. However, examining historical financial statements is a kind of necropsy that does not help very much to reach optimal financial decisions.
The most important management function is to increase the value of the firm. In this paper we present how the future decisions can be evaluated in terms of measuring the behavior of the firm value, given a decision to be analyzed. We also show the limitations of the traditional financial ratio analysis in reaching the target of maximizing the firm value.
Note: Downloadable document is in Spanish.
How the Regulator Overpays Investor? A Simple Exposition of the Principles of Tariff Setting
Rauf Ibragimov, Joseph Tham, Daniel Toro González
In this teaching note, we discuss the basic principles for tariff setting. Tariff setting is very important for... more
In this teaching note, we discuss the basic principles for tariff setting. Tariff setting is very important for regulated industries, such as water and power. The tariff should provide an appropriate risk-adjusted return to the investor. If the tariff were too low, then the investors would not be willing to invest. On the other hand, if the tariff were too high, then it would reduce the consumers' welfare.
We examine the Rate of Return method for calculating the tariff in a regulated firm. In the rate of return method, the tariff compensates the investor for all the costs that the investor incurs, including a fair return. We use the discounted cash flow approach to value the return that the investor receives. The results of both calculations must be consistent.
In particular, using simple examples, we show that in the presence of a positive expected inflation rate, the typical tariff calculation, Rate of return method, is an overestimation of the required payment to the equity holder.
Forecasting Foreign Exchange Rate in Colombia Assuming PPP Conditions: Empirical Evidence Using VAR (in Spanish)
Co-authored with Catherine Fayad Roberto Fortich
In this paper we evaluate a set of colombian exchange rate forecasts during the 1995-2005 period, using a Purchasing... more
In this paper we evaluate a set of colombian exchange rate forecasts during the 1995-2005 period, using a Purchasing Power of Parity Exchange Rate Model (PPPER). Our first finding is that the computed forecasts seem to validate the use of this model under certain conditions given that, theoretically, it does a good work in predicting the long-term behaviour of the nominal exchange rate. Our second finding included a comparison analysis of out-of-sample forecasts (saving the 2001-2005 historical data) between the PPP-based forecast models, and the Vector Autorregresive (VAR) ones. The VAR method has a better forecasting performance, according to the RMSE, MAE and U-Theil measures. However, MAPE results measured on the first and second month-ahead forecasts, indicate that the VAR model has the worst performance amongst PPP-based models.
Note: Downloadable document is in Spanish.
9 Terminal and Firm Value
This is a course material from the book Investment Decision Making. For Firm and Project Valuation. The book is... more
This is a course material from the book Investment Decision Making. For Firm and Project Valuation. The book is originally in Spanish and is untitled as Decisiones de inversión. Para la valoración financiera de proyectos y empresas.
Chapter 9 is a complement to the previous ones and is devoted to calculating the continuing or terminal value. This chapter closes the circle and ends the proper valuation process.
Note: Downloadable document is in Spanish.
Value Creation Revisited: The Economic Profit
This short paper studies the Economic Profit, a different label for the Economic Value Added, EVA. Copeland et al.... more This short paper studies the Economic Profit, a different label for the Economic Value Added, EVA. Copeland et al. (1995) show that the present value of the free cash flow and the present value of EVA (Market Value Added MVA) are not the same, unless the present value of future EVA (they call it economic profit) be added to the initial capital invested. This present value includes, in both of them, the continuing value, which is the present value of the perpetuity for the cash flow and for the economic profit. For both of them, they end up with the Entity Value and the Equity Value. They present an extensive example and it will be analyzed in this paper. In that example they show that both, Entity and Equity Value are the same when calculated through the free cash flow or the economic profit. In this paper that assertion is examined in detail. It will be shown with the same example presented by them, that it holds true only under very restrictive assumptions. This is, when WACC assumes a given value.
Subsidized Cost of Debt: The Relevance of the Research Question in the Financial Research (La Subvencion Financiera del Coste de la Deuda: La Importancia de la Pregunta en la Investigacion Financiera)
Co-authored with Mariano Gonzalez, Ana Mateos
The purpose of this work is double. On one side, we wish to examine if subsidizing the cost of debt has some influence... more
The purpose of this work is double. On one side, we wish to examine if subsidizing the cost of debt has some influence on the firm value (debt plus equity) or if it is just a transfer from debt holders to shareholders. On the other hand, we wish to show that research in Finance, as in many others fields of study, requires that the starting hypothesis to be tested, should have a correct formulation. If not, it could fix the ending results and hence they might be subjective.
We can draw two basic conclusions: First that cash flow valuation methods do not consider ll the possible scenarios, hence the posed problem should be considered as an American option of trading off assets in order to arrive to a correct valuation. Second, the question should be, why should we subsidize debt? Because once we know the cause, it is easier to define the effect.
Note: Downloadable document in Spanish.
Value Creation in the Firm/La Creacion de valor en la Empresa
This paper is a Spanish version of two previous papers published at Social Science Research Network: Value Creation... more
This paper is a Spanish version of two previous papers published at Social Science Research Network: Value Creation and its Measurement: A Critical Look at EVA and Economic Value Measurement: Investment Recovery and Value Added - IRVA. The first section is an introduction. In section 2 a conceptual framework regarding the Net Present Value, NPV, is presented. The NPV is a method for financial decision-making based on value maximization. In section 3, the need to measure value is presented. Section 4 studies the Economic Value Added, EVA. EVA is presented as it pursues to measure the same concept as the NPV does. However, EVA starts from accounting figures (profit) and NPV starts from net cash flows. In this section it is shown the correlation between the stock value for Coca Cola and some other indicators, including Economic Profit -EP- and some examples are presented where it is shown that EVA and EP do not measure value. In section 4 some adjustments for EVA and EP are mentioned. The concept of Market Value Added is studied and the coincidence between MVA and NPV is examined. Examples are presented where some inconsistencies between the two measurements are found. In section 5 an alternative to the measurement of value is presented: Investment Recovery and Value Added. It is based on free cash flows, implies the investment recovery schedule and the discounted payback period. A procedure to calculate the real cash flow is presented. In section 6, we conclude.
English versions of two previous papers are also at SSRN: Value Creation and its Measurement: A Critical Look at EVA http://papers.ssrn.com/abstract=163466 and Economic Value Measurement: Investment Recovery and Value Added - IRVA http://papers.ssrn.com/abstract_id=223429
cash flows