A discussion over the book- principal of cash flow valuation

www.futurumcorfinan.com

Page 1

A Discussion over the Book:

Principles of Cash Flow Valuation (2004) by

Joseph Tham and Ignacio Velez-Pareja Part 1

Book being discussed:

Tham, Joseph; dan Ignacio Velez-Pareja. Principles of Cash Flow Valuation: An Integrated

Market-based Approach. London (UK): Elsevier, Inc. 2004.

Note:

Karnen : Sukarnen (a student that never graduated from life lessons)

IVP : Ignacio Velez-Pareja

Sukarnen

DILARANG MENG-COPY, MENYALIN,

ATAU MENDISTRIBUSIKAN

SEBAGIAN ATAU SELURUH TULISAN

INI TANPA PERSETUJUAN TERTULIS

DARI PENULIS

Untuk pertanyaan atau komentar bisa

diposting melalui website



Page 2

Karnen:

Hi Ignacio,

I just finished reading your book, up to chapter 4.

IVP: Great!

Karnen:

On page 79, the matrix WACC for FCF and CCF - they are all for perpetuity situation, right? I

guess in other chapter, you are going to show the matrix WACC for FCF and CCF, under non-

perpetuity (finite streams of cash flows) situation, is that correct?


Page 3

IVP:

Yes, perpetuities. See, for instance, the formulation for Ke that includes (1-T) because in

perpetuity VTS = TD

Karnen:

Chapter 4: I could see why it is not iterative:

The interest expense on loan, is computed on Loan Balance (t-1) and not Loan Balance (t)...

IVP:

Why with Dt? In reality it is KdDt-1! Un less you contract loans with anticipated (in advance)

interest. Even in the case of advance interest payment, you can recalculate Kd to have it at the

end of period. i_adv = i_end/(1+i_end) and i_end = i_adv/(1-i_adv)

Karnen:

You build the financial model from constructing CB and IS, and not from the BS (which is

normally that we do by utilizing the financial ratios, linking balance sheet and income

statement). It seems to me, BS is the product of what we put into CB and IS.

IVP:

Sure! Remember the model in no plug etc. We start from basic inputs: quantities, real increases

in prices, inflation, policies, etc. and construct intermediate tables where we show how many

units we sell, at which price, how many units we should buy and at what prices, etc. All this ends

in the CB (or Cash Flow Statement, CFS) and the IS and finally, the BS. Unless we cannot find

units, etc., but sales revenues, we proceed in a different way. For instance, we can estimate

historical "real" increase in sales that combines dP and dQ. We have to find out how to estimate

dP and dQ. One alternative is to identify what I call the demand driver. My favorite example in

classes is diapers. Who consume diapers? Babies (say from 0-5 years) and old people (say, 85

+). Then we can have disciplined estimates of increases in those age groups and hence it is a

good and fair estimate of dQ. Hence, we can estimate dP using Fisher. For the forecast, we can


Page 4

check with the Statistics Governmental Office which are the forecast of population by age

groups and use that as dQ forecasted. That is what I call inertial or vegetative demand. If I wish

to have a larger growth, I have to invest in promotion, advertising, etc.

The ideas about the model are the same as in those papers on no plug. The difference is that

the model has been improved since 2003-2004, but the basic and critical points are the

definitions of ST and LT deficits to define loans and new equity contribution and the definition of

excess cash or superavit.

That is all. Well, also the idea of WACCs and Ke for finite cash flows.

Thanks a lot for your interest.

Best regards and let me know your advances and critical opinion on the book

Karnen:

Hi Ignacio,

Thanks for your reply, really appreciate it. I will definitely sleep with that first.

By the way, just very quick, on Table A2.1 and Table A2.2, the formula for WACC (not Adjusted

Value) both are the same, whether the discount rate for TS is ku or kd (or risk-free in your

book), though the formula for getting the ke is different. Can you kindly give me the insight as to

why we could end up the same formula for WACC?

IVP:

Yes, it is simply because the traditional WACC is a weighted average! The difference is in Ke!

That formula could be easily derived thinking on what is expected to be received by debt and

equity holders from the firm: KeE and KdD, but the firm received the TS. Hence, for the firm,

net, it expects to pay KdD + KeE - KdDT. (no subscripts). The firm expects to pay that for

V=D+E. Hence you divide through V and get KdD%(1-T) + KeE% (no subscripts).


Page 5

Karnen:

It seems to me, that in perpetuity situation, we could on safe side to use the traditional WACC,

not too much worrying about the discount rate assumption for TS (since they end up on the

same formula), and forget the ku as well since it is not too easy to get it anyway.

IVP :

The problem with using traditional WACC is that it assumes several thinks that might not hold.

1) The only TS are from interest; however, you might have other financial expenses such as

losses in exchange, for instance.

2) You always have enough EBIT + Other Income to offset financial expenses. Didn't I talk

about a segmented function to calculate TS?

3) You pay taxes the same Year when provisioned. These conditions not always hold.

Best regards

Karnen:

Dear Ignacio,

I clapped my hands for your simple insight!

Just popped up on my head, if WACC is just a weighted average of kd and ke, and I am talking

about FCF (as this is normally what analysts use in valuation), then what is the big deal to have

the explicit assumption for TS discount rate? (since anyway, ku cannot be observable). From

M&M traditional WACC, they assume kd is the discount rate for TS.

Kind regards

Karnen


Page 6

IVP:

Dear Karnen

Well, here is "the problem" for you. You always say that Ku is not directly observable! Yes, you

are right! BUT if You don't use Ku derived or defined somehow, you will need to lever and

unlevered beta if You use CAPM and if you recognize that Ke changes with leverage! Hence,

sooner or later you end up dealing directly or Indirectly, with Ku via the unlevering/levering beta

procedure!

That is a hidden way to work with Ku, and perhaps people don't realize It. If that is the situation,

let's assumes openly the use of Ku, the unlevered cost of equity. And the unlevering is done

right away at t=0!

Which is the alternative? To blindly use a constant WACC or constant Ke. This for finite cash

flows is clearly wrong. The other option is to forget of finite cash flows and assume a perpetuity!

Now, you tell me, Which scenario you would prefer.

Once you define that, you can keep reading the book or throw out the chapters you don't need.

You follow? At the end of the day what you have decide is in Which imperfect world You prefer

to live in!

All this might sound disappointing to you, but that is reality.

Best regards

IVP:

Dear Karnen

I forgot to comment the main part of your message.

Yes, M&M assumes Kd as PSI, the discount rate for TS. You can assume any value or Ku or Ke

or Kd Again, you decide in Which world you wish to live in.


Page 7

If you decide it is Kd, the M&M world, and You decide a finite world, and use ONLY FCF, then

you have to use Ku directly or Indirectly. And you have to deal with changing D/E to adjust Ke

and consequently, WACC.

Now, if you recognize that the firm has financial expenses different or in addition to interest

payments or you want to consider a firm that eventually has losses, then you cannot use the

traditional WACC formula and you need to deal with the discount rate of TS!

That is all the fuzz about the discount rate for TS! Sooner or later you will be confronted with it,

unless you decide to work in the idealized M&M world of perpetuities. Once you Try to be near

reality, your models become more complex. Remember the Manifesto!

Best regards

Karnen:

Hi Ignacio,

Yes, I agree with, theoretically you are not wrong.

So, what do you suggest? finite period - Ku and perpetuity, kd for TS?

IVP:

What I do is assume Ku and use CCF. The simplest way. I estimate Ku either using Damodaran

unlevered beta and/or asking the investor. That is it. Finally you end up sensitizing all the results

with the discount rate. What I do with Ku? If inflation is constant, I keep constant Ku, if not, I

deflate Ku at t=0 and inflate every period with the proper inflation and that is it. I find E as V-D.

That simple. I have demonstrated that ALL methods give the same value, hence I do that

Karnen:

If we stand here at instant t=0, do you think WACC, leverage, and ku cannot be assumed away

as constant? Business risk, yes changes, but how to measure it, how to know it? It's not easy to

know it, let alone, to measure it (accurately). To give number to ku is quite problematic.

Changing that along the way also doesn't make sense, as we surely do not know.


Page 8

IVP:

See above. However, if you prefer to use FCF then I use WACC = Ku - TS_t/V_t-1. With this I

can handle ANY kind of TS and cases when EBIT <0 and 0<EBIT<Financial expenses. If I use

CFE Ke = Ku + (Ku-Kd)D_t-1/E_t-1. This way you pick up the financial risk due to leverage.

In both cases you have to handle circularity with Excel. Very easy.

Karnen:

Sorry, still I agree with your book approach, and I will manage to use the CB to avoid the plug

method, but the discount rate, it seems to me, it is just about being consistent, though being

consistent or not consistent is not necessarily leading us to the correct intrinsic value. As some

say "the freedom to speak does not mean that we need to tell the truth".

IVP :

Doing what I say above, you is correct within the Ku world and consistent among methods.

Consistency doesn't mean correctness. Which is the correct world? I don't know and I don't care

too much. Differences in psi assumptions are not that big.

Karnen:

Thanks for your time and kindness in replying me. This will certainly help lift up some heavy

dark clouds off my head. I'm now into chapter 5, but still that chapter 2 sticked with me with a

hanging question, why we need to spend so much time, just to make sure we have the "correct"

assumption for TS. At the end of the day, it is just an assumption. We will never know which one

is correct. Even, ex-post analysis of our valuation will not help much. We will never know,

whether the actual value that is different from our detailed expected valuation analysis is coming

from forecasting error or from discount rate.

IVP :

See above. I think that I answered that concern. In short, I adhere to the assumption that gives

me the simpler formulation. You know I have worked the assumption for Ke that can give the

optimum capital structure and for CFE it doesn't have circularity, but I think anyway, that

assuming Ku is simpler.


Page 9

Please note that with ANY assumption you need Ku or need to unlevered and lever beta that at

the end of the day is what you do to get Ku!!!

Best regards

Karnen:

Dear Ignacio,

I refer to Table 6.12 (page 249), I cannot find how you calculated the amount for the line of "net

increase (decrease) of cash during the year"? It is said "cash", is this included "marketable

securities", I included that but still cannot figure it out?

IVP:

Dear Karnen,

Please see this Errata posted in the web page of our book several years ago:

http://cashflow88.com/decisiones/principles/errata.htm.

There, we corrected that table. Perhaps there is a mistake there because the page numbers it

say 248 and the table is at p. 249, but the issue starts at 248.

We never have had such a dedicated reader as you! Many thanks. You are the first to catch that

typo.

Karnen:

In Chapter 6, you mentioned about "excess cash/marketable securities". How are going to treat

it, part of FCF (since they are in reality still retained in the firm) or as other book suggested, put

that part of net debt (though I don't really agree this treatment, since the ACTUAL return of

excess cash (which is lower) and debt is different (blending it, and discount it using kd, a bit

strange to me, though many textbooks support this).


Page 10

IVP:

Well, this is my old fight against what they call Potential Dividends. Potential dividends arise

because they use the OWC (Operating Working Capital) that doesn't include cash nor

marketable securities in it. The effect of this is a great inconsistency, because as you say, they

remain in the BS. In some cases that overvalues CFs and value and in others undervalues.

One cannot accept that something that is included in the CFs (for valuation) appears in the BS.

That is stupid, but that is what [Prof. Aswath] Damodaran, [Richard A.] Brealey & [Stewart C.]

Myers and other “teachers” teach in their courses and corporate finance textbooks. Obviously,

most practitioners follow them.

As you can notice we say Total FCF and Operating FCF. The difference is those Potential

Dividends. You can see a discussion on this in two papers by CA Magni and me.

A major inconsistency is that a management decision to keep cash and invest in marketable

securities that destroys value, (IRR = 0 or near 0%) appears in the FCF creating value! This is a

problem that doesn't occur with the direct method. In this method you "see" the CFs in the CB in

module 3 and 4 (with different sign because it is from the point of view of the firm and not of

investors). There cannot be any discussion or interpretation of those CFs in the CB. THAT is

what the firm expects to pay to banks and shareholders.

I happily see that you agree with us in this issue. AM I right?

Karnen:

Hi Ignacio,

Another stuff I think when finished chapter 6, that chapter doesn't mention anything about

"sustainable FCF or CCF" at the end of the day, the valuation will involve all cash flows

(whatever cash flows, we are going to use) as sustainable.


Page 11

IVP:

Dear Karnen,

When you say "sustainable" I assume you are thinking on steady state. Isn't it? Or do you refer

to reinvesting say, depreciation to keep the firm going?

When we deal with terminal value we mention the idea of steady state. Please clarify that

because it might be a missing issue in the book..

Karnen:

Hi Ignacio,

Regarding sustainable cash flows in the valuation, I believe, conceptually, that companies need

to determine their sustainable cash flow from ongoing operations in order to estimate how much

cash will be available for discretionary spending, such as capital expenditures for increasing

productive capacity and acquisitions, and for distributions to shareholders through dividends

and share repurchases. This is not JUST deriving the FCF from CB, IS and BS, CFS, and then

we could prove it that is consistent...again, consistent doesn't mean it is correct (?).

IVP:

Now, see below for the core of your message.

As said in a previous message, consistency is desirable, but it is part of being correct. The

question is which is the correct discount rate for TS? The question is how we determine the

value of Ku? The question is should we ignore the change in capital structure and assume Ke

constant (and WACC)?

What gives sustainability to the CFs of a firm? Well, that is the BIG question. The most obvious

answer is demand, inputs, assets, etc..... If demand shrinks either you close the business or

change it adapting to the new situation, i.e. the music industry and others. In reality what you

are pinpointing is where are the value drivers of a firm. You can hear and read all the craps they


Page 12

write about value drivers and see and hear that EBITDA is the value driver. Well, that is

WRONG! EBITDA is an output! The real value drivers are in the input variables. When you put

there X% increase in unit sales, how do you support that? How do you take into account the

competition when setting those values for growth in units?

The issue of excess cash, I think it ALWAYS should be put in the place we expect they are. If

you distribute it, you put it in the CFs, if you don't, you keep it somewhere.

OF COURSE the issue is not to pick the CFs from CB, IS or whatever. Those are outputs that

are the result of some management decisions on what to do with your funds. You pour those

decisions into the model. For instance, I could say I wish to show to debt holders that my D%

(book value that is what the "market" sees) is lower than X%. Well, I have to increase retained

earnings, increase cash in hand, increase/decrease repurchases, whatever. And all that is

introduced in the model. Then the model is much more than a tool to derive CFs and get value.

It is a management tool. I insist that valuation should not be seen as a tool to be used when I

wish to sell or buy a firm. It should be a managerial tool that reflects policies and decisions.

Karnen:

It is to assess a company’s long-run profitability and value. In practice, this is not easy,

meaning, what is sustainable for creditors, doesn't automatically mean it will be sustainable for

shareholders. This is why we see valuation analyst look at the enterprise value instead of equity

value, since it is easier to assume away that on enterprise value level, we could have a better

projection for sustainable cash flows (to the Firm).

IVP:

Of course you have to watch total and equity value.

Karnen:

Regarding the excess fund/marketable securities, I could see your point and I concur with that. I

guess, in valuation practice, I need to see first the impact to the resulted value, if we treat it as

part of FCF instead of netting it against debt. But again, the issue whether the excess


Page 13

fund/marketable securities are sustainable to be included into FCF. We are looking for

sustainable FCF, which is the point. Excess cash/marketable securities might not be

sustainable...meaning that we have no idea what the company will do that in the future. If they

don't have much positive-NPV investment opportunities, and the interest rate in the market is

down, it is highly likely, the company will pay off its higher-interest bearing debt, or under the

free-cash-flow theory, it will go to dividends to reduce the possibility of the management to

squander off the money to projects to make the company bigger, but not profitable.

IVP:

Agree. See above. Use your valuation tools to financial management. Listen, I think that

textbooks on finance have done too much harm to financial management stressing the analysis

of PAST performance. I don't care that last year I had a current or quick ratio of 2.3 if I don't

have the funds to pay the payroll next week. We have to stress forward looking financial

analysis. And if you have your forecasted CB, IS and BS, you don't need to look at the

traditional financial ratios or the use and sources statements! Instead, you DESIGN them! You

can see if you have a short-term deficit or not; if inflows from AR (= Accounts Receivable) are

enough to pay suppliers and payroll, etc. If that happens, go to your inputs (policies and prices,

growth, etc.) and see what is wrong THERE. I say that traditional financial analysis is a

necropsy!

Karnen:

So in other words, we need to build some assumptions, what is going to happen in the future for

the company, as part of the consideration, whether we need to include excess fund/marketable

securities as part of FCF or netted against debt, or dividends.

IVP:

See above. Do with excess fund/marketable securities what you plan to do and if you keep

them, don't include them in the FCF if not, and you distribute them, put them in the CFs. That

simple. See above, again.


Page 14

Karnen:

I forgot to include the question: about the CRO, you include the changes of CRO under 'working

capital" or net against debt (similar treatment as excess fund/marketable securities). I am in now

chapter 6, but the way the chapter presents so many ways to get into FCF, a bit confusing to

me. I know the intention is to show that there are 1000 roads to Rome (via CB, CFS, CCF,

operating + non-operating,....).

IVP:

Dear Karnen,

We never net cash with debt. If cash is in the BS, it is part of the working capital.

I would put the issue in these terms: CB reflects distribution of CF policies. Hence, for good or

for evil, that is what we expect to pay owners and debt holders. If your procedures to estimate

CFs arrive to a different CF, there is something wrong. If you don't like the CF that appears in

the CB, go back to your inputs and policies and see what is wrong and correct it; don't change

CFs using tricks in your recipe. CB show what CFs really are! What change could you make?

Ok, set CRO =0, increase the payout policy; decide not to invest in marketable securities and

distribute cash, etc.

Yes, several ways to go to Rome! The message is VERY simple: there are no better methods to

value a firm and ALL of them are correct. Apply a simple rule: don't do with more what you can

do with less. Hence, although we show how to do it with all methods and show they match, I use

the simplest ones: one, define CFs from the CB that is free of errors and use CCF. However, if

you prefer FCF, do it, but also check with the easiest one: the CC

The purpose of using the operating and non-operating CF is just to show that the operating

deviates from the "real" CF that appears in the CB that, as said above, is what we expect it will

occur. Again, for us the correct CF is the one that reflects all the policies we have defined and

that those policies are reflected in the financial statements. Hence, if we define CRO >0, that

CRO appear in the BS; if we wish to distribute that, we set CRO=0 and in the BS should appear

cash =0! And so on.


Page 15

Karnen:

By the way, I am into chapter 7 now. Can you show me which page that gives me the table for

discount rate WACC (FCF) and WACC (FCF) and adjusted value for situation under no-

perpetuity (or finite streams of cash flows)?

IVP:

Let's start for the easiest part. Those tables are 7.3 and 7.4 at page 276. You can add an

additional one with the expressions I sent some weeks ago regarding Ke as psi.

Page 276: Table 7.3 Third formula, third element in the formula. It says VLi and it should say

VLi−1


Page 16

Note from Karnen: I have reworked the above formulas and find them mathematically correct,

depending upon the discount rate assumption used for TS. This works for finite streams of cash

flows.

Karnen:

I will take a look on the errata that you sent me the link.

Hi Ignacio, you said you have 2 papers with CA Magni:

I have one titled : Potential dividends versus actual cash flows in firm valuation (2009). Will

read it through by end of this week.

Another one, what title is that?

IVP:

In another message you ask for the papers with CA Magni. You can find both at

http://papers.ssrn.com/abstract=1374070 and http://papers.ssrn.com/abstract=1095068. They

are theoretical. However, we worked that out with some data and you can see the results at

http://papers.ssrn.com/abstract=1175482.

Again, the main idea is that something that destroys value (cash in hand and marketable

securities) cannot, by using a tricky inconsistent treatment of the recipe to derive CFs, be

converted into a value creator. Follow?

Yes, you create value when you draw out funds from the firm.... To shareholders (and

debtholder). If you keep funds as cash or in market secs, that is investing money in NPV<0

investment. Shareholders would ask management, distribute it. We can get more than you are

getting now! Hence, an increase in cash is not un the hands of owners and when using Potential

dividends, you are inflating (or decreasing) the CFs.


Page 17

Karnen:

Hi Ignacio,

I refer to footnote 5 (page 275).

What makes me a bit confused.

We do know all debts are risky due to the possibility of default and interest (the major ones). We

do know that from the perspective of debt holder, all those risks have been factored into the

debt interest (as part of higher risk premium) and debt covenant and collateral.

So, even if the debt then becomes default, as far as I know, the interest will still tick on, and the

debitor will have to accrue to this interest expense, and be entitled to tax deduction (thru LCF).

So TS is not that "risky" as the debt.

IVP:

Agree.

Footnote says that Kd is risky and yet, some (such as M&M) use Rf as discount rate for TS. We

try to distinguish between M&M do using Rf and what we does that consider several options for

psi.

In fact, we say Rf, Kd and Ku.

Karnen:

By the way, M&M uses Kd as the discount rate for TS and they assume a permanent debt. It is

not Rf as you put above.

IVP:

If you say it is Kd, it must be.


Page 18

Karnen:

Then why we put the discount rate for TS similar to Debt?

IVP:

We prefer not to use Kd (and of course, Rf).

See this: in some way TS is a function of EBIT+OI. Hence, TS follows the following segmented

function, as I have mentioned before:

If EBIT+OI <=0 ==> TS = 0

IF 0<EBIT+OI<Interest (in rigor, financial expenses) ==> TS = Tx * (EBIT+OI)

If Interest<= Interest,==> TS = Tax * Interest Expense.

This might be a signal that Ku is the proper discount rate.

However, when you define CFE = FCF + TS - CFD (equity and CFE are a residual concept) you

SEE that TS belongs to shareholders and when they expect and receive the check for dividends

they don't ask for how much is dividend and how much is TS. Hence, psi should be Ke!

Remember I said that Joe and a colleague (Nick Wonder) wrote a paper where they show that

using ANYTHING as psi, you get consistency. However, then we can raise the question of "is

consistency enough to say that the assumption for psi is correct"? The answer might be NO! In

fact, you get consistency [even] with Rf and Kd!

The main issue here is that, not many people are aware about the idea of the discount rate for

TS. And they blindly follow M&M and Myers (APV)! The difference is that we make explicit the

assumption in each case. That is shown in the file and the tables where you find the collection

of formulas for each "world".


Page 19

Karnen:

Dear Ignacio,

Page 267, second paragraph, the last two sentences, where you claim:

e (levered) > ku (unlevered)

ku (unlevered) > d

There is no much explanation as to why it is so....

To me, we need to link it to the three main risks: business risk, operations risk and financial risk.

Ku (unlevered) > d, because debt holder doesn't assume business risk, while unlevered equity

holder assumes business and operations risk.

Ke (levered) > ku (unlevered) because levered equity holder assumes business, operations plus

financial risk.

Simple.

IVP:

Dear Karnen,

Yes, you are right! That deserved that comment. I remember I said I liked your explanation, that

in the Spanish book it was explained defining the conditions for debt and equity (a contract,

collaterals, insurance, priority in payments over equity, etc. ). And I said I would use your

response giving credit to you! Could you check that you have received that?


Page 20

Karnen:

Hi Ignacio,

Page 265: it is said..where the interest payment is equal to the value of the debt AT THE

BEGINNING OF THE PERIOD...yet in (7.9), you don't put the subscript i-1 to the D? Is it typo

error?

Page 266: footnote 3: if the debt is risky, TS might not necessarily be risky....

Can you kindly elaborate it:

What do you mean with the debt is risky..I thought all debt is risky (due to default and credit

risk)?

If debt risky, but TS MIGHT NOT necessarily be risky...why you use "might not"? the sentence

is quite ambiguity..Under what situation it is risky and it is not risky?

IVP:

Let me go back 10 years ago and see if I can reconstruct our thinking at that time. And yes, it

also deserved an explanation. Have to think it over and try to find why we wrote that!

I have to confess that today, even if I have some arguments to defend Psi = Ku or Ke, in reality I

cannot say I have that solved in a complete way. That has a good side because it is an

opportunity for some nice work.

Yes, theoretically, there is some risk free debt (T bonds, say) but in practice all debt has a risk.

You are right.

Thanks again for your interest, for your detailed and thoughtful reading and for all your inquiries.

We really appreciate that.


Page 21

Karnen:

Hi Ignacio,

On page 281, Table 7.7a: I tried to recalculate your calculation, I guess it is not quite right. For

example, Year 4, row "Levered Value",

The table shows 55,709.30, however, when I put FCF Year 5: 66,916.43/(1+20%) = 66,763.69?

I am trying to look at the Book Errata, but there is no indication of such error, or typo error.

Do I miss out something in figuring out the table calculation?

I see that comparing Table 7.6b and 7.7b, they are pretty much the same, the authors just want

to show that we could use either WACC or adjusted WACC (started from ku - TSi/Vi-1), and

both will give us the same results.

Thanks very much anyway for all your brilliant answers. I learnt a lot from all these discussions.

I should sit in your class and I do believe we will have very enlightening discussions.

IVP:

Dear Karnen,

Yes, you are right. I went over the final files we sent to the Editor and in chapter 7 it is correct

and different from the printed version. The table 7.7a is


Page 22

Please find attached last version we sent. I don't know what happened there.

Karnen:

Hi Ignacio,

Upon looking at Table 7.8 (page 282), with ku as the TS discount rate...Gosh…This assumption

makes the hellish simplicity out from those books on valuation that I have had ever read them.

IVP:

Why so surprised? I have been telling you that ALL methods yield the same answer! THAT is

what you will find (and you can do as a homework).

Karnen:

Just one table, put Ku as TS discount rate, and all we need is CB on hand, that is pretty much,

management has already had it as their monthly management tool.


Page 23

IVP:

Yes, that simple. Remember what I told you recently: Don't do with more, what you can do with

less.

Karnen:

This makes me remember: Finance scholars figure out some ways to measure and control risk.

More important, they figure out how to get paid (very high) for doing so.

I do believe, so many MBA graduates, not aware of the simplicity of having ku as their TS

discount rate. They don't even know that there is such assumption.

IVP:

YES!!!!

Karnen:

Having said that, I need get back to real world, still. As an investor in the market, ku is not a

familiar stuff to say. Their language of expected return, is [after tax] levered rate of equity return.

So it is not wrong, that all finance scholars (even M&M) started their discussion by referring to

ke and then re-lever it to ku. However, by doing this, they still don't really tell us what explicit

assumption they use for the TS discount rate. They assume only one single "world" to exist, and

that’s their formula. Smile.....

IVP:

Dear Karnen,

What you do unlevering/levering betas (and Ke's) is the same shitty procedure we do when we

use the unlevered beta from Damodaran to estimate Ku!!!! Please re read my recent messages!


Page 24

Karnen:

Hi Ignacio,

Continued from my email above.

As you put it, the return to levered equity is the function of psi...from the investor's perspective in

the market, what is the relevance for them to specify what psi is...to them, return to levered

equity is what they are going to get from the next best investment return. "Opportunity cost of

capital".

IVP:

Listen, YOU pick one assumption. You don't need to tell the investor about psi. He doesn't give

a penny for that. Find out the unlevered beta using IQ-Capital info or just simply use Damodaran

[version]. Then calculate WACC and/or Ke. Once you decide for psi, stick to the proper table for

the proper formulas and that is it.

Karnen:

Yes, from finance theory, we do know that it is hellish important to specify the psi, since, that will

critically impact the unlevered rate of return, and CONSISTENCY among all ku, ke, and psi.

IVP:

Forget about the importance of psi regarding the amount or "error" using one or another. See

above. Adhere to one psi and act consequently when defining formulas for WACC and Ke.

Karnen:

Sorry, what clouds my head is,

First, do we need to inform the market, that they need to tell us what psi, they are going to use,

since we have all different "world" to use in our valuation?


Page 25

IVP:

No. YOU don't have to tell the market about that; the market WILL NOT answer that question.

The market is blind to psi's, formulas, consistency, etc. Just define the appropriate psi you

prefer or believe. The debate is not over about the proper psi. What I do? I assume Ku although

I cherish Ke. When I show the investor the numbers I say that discount rate is X% without giving

too much explanations. Well, I can justify Ku using betas. I use that just in case the investor is

"educated" and he is sensible to that language. If not, just check that your Ku or discount rate, is

consistent with his/her expectations of return.

Karnen:

Second, on "opportunity cost of capital" in the market, what have the psi to do with the market?

Do we have market for psi? What I meant, we have market for ku, we have market for ke, we

have market for kd, but how about psi?

IVP:

See above. Forget the market talking about psi. If scholars are not aware of that, what do you

expect the market will do?

There is no visible Ku in the market. You see Ke TODAY. Just unlevered that Ke if you believe

in that. And that is what Damodaran does and what you can do using IQCapital info!!!!

Karnen:

Dear Ignacio,

When somebody told me that this formula is working under the assumption that....that always

makes my eyebrows raised up...

In the market, when the investors say "assume", they mean they speculate...but this assumption

is different, since all they are correct mathematically..


Page 26

IVP:

Market has a dynamic that doesn't obey to formulas or assumptions. They trade and reach a

price. Using those prices scholars calculate betas and unlevered or lever them. CAPM is a nice

tool to guess what N investors in a firm might or should expect about their return.

If you have access to the investor (say in a non-traded firm) simply you could ask them "what is

your expected return?" And they might answer, 55% and then you reply, look you are crazy; see

the market returns in similar investments. Would you reconsider your expectation? Also, you

could tell them, that the higher his expectations, the lower the value of his firm!

In short, you try to guide the investor to his MINIMUM expected return!

Karnen:

All those formula tables are correct, depends on the assumption of psi...and this is a bit

troubling me,,,the levered return of equity is the function of psi....this sounds strange and not

easy to explain it away to investor. Since they don't think that way..

IVP:

See my previous messages on that, please.

Karnen:

Interesting....always a joy to read your reply...the words are like a rainbow of joy...thanks

I am into Appendix A of Chapter 7. I take a quick look, and that sounds like the other appendix I

read before, the derivation of the formula table, WACC, adjusted WACC for FCF and CCF. Will

manage to do it myself tomorrow. Now I understand it, and not too difficult to do it myself, just

stick to FCF + TS = CFE + CFD. the magic equation, like Debit = Credit. As clear as the crystal

skull is....


Page 27

IVP:

YES!!! I say that in my classes. It is the same as the double entry principle in Accounting! And

it is true!!! Assets = Liabilities + Equity. Only that not all liabilities are debt! (Financial debt).

Dear Karnen,

Additional comments.

Don't be afraid of simplicity. Just unlevered Ke only once and you are done. Now you will have

MORE TIME to think in the business, in the construction of a model, that although it is not the

world, you might construct it as close as possible to reality; etc. Look for the nice side of it!!!!

On the other hand, let me show you a beautiful harmony or symmetry between CCF, FCF and

their WACCs, assuming psi=Ku.. See:

Notice that when the only source of TS is interest, you have enough EBIT to offset the financial

expense TS/V = KdTD/V and you easily arrive to the traditional textbook formulation. THAT

formula IS NOT a general formulation of WACC. Instead, it is a very particular case: a) You

have enough EBIT+OI to offset financial expenses, you pay taxes the same year and you have

TS with only one source: interest charges. Remember that if your customer is globalized, she


Page 28

might be subject of losses in exchange rate, for instance, that is a financial expense, BUT is not

captured by the interest rate (or by Kd(1-T)D, which is the same).

FCF < CCF and has no effect from taxes on interest (TS). If you discount that with Ku, you

would lose the VTS that is part of value. For that reason they call it unlevered. However, that is

a misname, in my opinion. FCF is not unlevered, but without the effects of TS. (FCF = CFD +

CFE -TS). How do you recover that? Discounting FCF at a lower WACC

(WACC_FCF<WACC_CCF). This is the effect of (1-T) or -TS/V.

On the other hand, CCF HAS the effect of TS in it (CCF = FCF + TS = CFD+CFE). How do you

eliminate that TS that is within the CCF? Discounting it at a higher WACC (WACC_CCF = Ku)

Do you see what I mean?

In the case of Ke, you just are adding the financial risk to Ku, This is Ke = Ku + (Ku.-Kd)D_t-

1/E_t-1. There might be periods where D=0. What is the result? Ke = Ku + (Ku-Kd)0/E_t-1 = Ku.

Now back to the beginning. You and many others are used to unlevered and lever Ke. Again:

You unlevered the Ke that you know TODAY at t=0 and you have Ku as per today. If it happens

that your forecasted inflation is not constant, then your Ku will change. How could you handle

that? Very simple. You deflate the actual Ku (t=0) with the known inflation rate at that time and

you obtain ku, the real Ku. Now what?. Then, for every year, you inflate ku with the respective

inflation rate and that's all. You have your Ku varying with inflation rate. What are you using

here? Fisher equation: (1+Ku) = (1+ku)(1+inf) or ku + inf + inf*ku.

This is what I can say regarding the use of Ku either as a discount rate for CCF or an input for

WACC and Ke.

Karnen:

Hi Ignacio,

Page 285 formula A7.10:


Page 29

The third component, we have [ku (i) - psi (i)] * VTS (i-1) / EL (i-1). I believe VTS(i-1)/EL (i-1) will

be very small (to the point, probably, meaningless), and more, we multiply the very small

(0.0000000) ratio against the DIFFERENCE between [ku(i) - psi(i)], the impact from this third

component, I believe, will not be significant to e(i). Mathematically it is correct, yet on practical

level, we could just disregard this third component. What is the implication? We don't have to

worry too much on TS discount rate, since it will be sufficient to know only ku, kd and the debt to

equity ratio.

What do you think?

IVP:

Dear Karnen,

Thanks for your continued interest in studying our book!

Yes, you might be right. Even, if you see the example I sent (Step by Step) the results and their

differences might be neglected. See

The problem is that we cannot say a priori that the differences are going to be significant or not.

For instance, I cannot generalize and say that given this hypothetical example where I picked up

from the thin air Ku = 15.1% and Kd=11.2% and Tx = 35% and initial D = 375 and the CFs and

such and such... that even it makes no difference in using Kd, Ku or Ke as psi. I would be more

than happy to say that psi=Ku because that simplify formulations; but on the other hand I would

like to use Ke if I expect to find an optimal capital structure... In other words, we are confronted

with a dilemma as poses Shakespeare in as you like it:


Page 30

"CORIN And how like you this shepherd's life, Master Touchstone?

TOUCHSTONE

Truly, shepherd, in respect of itself, it is a good

life, but in respect that it is a shepherd's life,

it is naught. In respect that it is solitary, I

like it very well; but in respect that it is

private, it is a very vile life. Now, in respect it

is in the fields, it please me well; but in

respect it is not in the court, it is tedious. As

is it a spare life, look you, it fits my humor well;

but as there is no more plenty in it, it goes much

against my stomach. Hast any philosophy in thee, shepherd?"

Karnen:

Hi Ignacio,

Page 290, equation B.7.5 that is CAPM-based equation for e (I). You said there that equation

B.7.5 is based on a specified leverage.

As this B7.5 is using CAPM, I am trying to recollect my memory whether when Sharpe derived

that CAPM formula, did he use a specified leverage? I need to dig out my Investment book, but

as far as I remember, there is no mention about a specified leverage by Sharpe. Do I miss

something here?

IVP:

Yes, we said that. The meaning of that expression is that betas are estimated using data from a

firm that has a specific leverage. It is an actual firm. And hence, when you wish to find an

unlevered beta what you do is to unlevered it using the specific leverage of that firm.


Page 31

Karnen:

Page 290, Equation B7.3, B7.4 and B7.5...using CAPM. I am not too sure whether we could use

such formula, as far as I know, Bill Sharpe never indicated that we could extend his CAPM into

debt and ku. SML probably, I say, probably, is relevant to ke, but not to kd and ku. The issue is

E(Rm) - Rf, which is making sense for a [well-diversified] portfolio of stocks. Richard Roll even

mentioned that that Rm should cover theoretically ALL RISKY ASSETS IN THE WORLD to

make CAPM working, the one that unfortunately, up to now, we still cannot see such portfolio

ever exists and traded in this world.

IVP:

Hahahaha!

Yes, those [that] ideal portfolio doesn't exist.

Well, I really don't know by sure if we can extend CAPM to Ku and Kd, now you point out that.

HOWEVER, I wonder how someone can say that debt has a beta. How would you calculate it?

The Bu is easy to assume that CAPM would work, I think. Just imagine a non-levered firm and

some of them exist. In that case, CAPM should work very well.

In the other hand, if debt is public (traded in the stock market) why not estimate its beta using

CAPM? If you don't use CAPM what would you use to estimate beta?

I appreciate your comment because we never questioned the idea of using CAPM to estimate

beta for Ku and Kd. However, we have to remember that in reality, most firms (99,7%) don't

trade in the market and even if they do, many don't have debt or don't have public debt. And

their debt if any, comes from banks or individuals.

I don't have a clear answer to your concern.


Page 32

Email from Prof. Robert C. Higgins (Prof. of Finance, Foster School of Business,

University of Washington, USA)

I don't see any problems with the equations you show. debt and unlevered equity are both risky

assets, and the CAPM applies to all assets. It might be a challenge to define and measure the

appropriate betas, but those are other issues.

Karnen:

Thanks Prof. Rocky! (IVP: OK, fine. Then the problem might be solved unlevering levered betas

for Ku from Ke. For public debt, there might be betas calculated as betas for Ke.)

Karnen:

Page 292, Table C7.1

What do you mean with Operating CFE? I am trying to find the content of Operating CFE from

chapter 6, but unfortunately, there is no such term being used in that chapter.

Operating FCF = NCB before debt + equity financing - taking out the tax on interest income +

movement in CRO

Operating FCF + TS = Operating CCF

Non-operating FCF = changes in marketable securities + interest income on marketable

securities - tax on interest income

But Operating CFE? Non-Operating CFE?

IVP:

You are right, we don't define that specifically. However, the explanation above might solve the

question.


Page 33

Karnen:

Under the line C7.1.2 Standard WACC applied to the FCF, "In the first row of Table A7.1..." I

guess it is a typo error, as it should be read "Table C7.1".

IVP:

Yes, you are right, but it should refer to Table C7.2a.

Karnen:

Page 291: Equation B7.6, Di-1/Ei-1, (without L), but in Equation B7.7, you add L into Ei-1...I

know that all Ei-1 should be the levered one, but probably it will be a bit confusing for new

reader on this topic, as it seems inconsistent in the presenting the formula.

IVP:

Yes, you are right. Perhaps it is better to use E without any superscript. B7.1 and B7.2 have the

same problem of superscripts.

However, now that you point out on this, when we derived the Ke expression assuming Ke as

psi we in fact use E(Un). See

Ke = Ku + (Ku-Kd)D/(E-VTS) or

Ke = Ku + (Ku-Kd)D/(VUn-D).

VUn - D = E - VTS = E unlevered!

But you can forget this because at that time we didn't imagine about Ke as psi, although Joe

and Nick Wonder wrote a paper where they say that psi could be ANYTHING.


Page 34

IVP:

Dear Karnen,

Remember where Operating FCF comes from: that arises when defining working capital

excluding cash and marketable securities and that gives as a result what some call Potential

Dividends. When you use the indirect method to calculate FCF and CFE and use OWC, then as

a result you have Operational FCF or operational CFE.

Karnen:

Hi Ignacio,

I copy here your response:

"Remember where Operating FCF comes from: that arises when defining working capital

excluding cash and mkt securities and that gives as a result what some call Potential Dividends.

When you use the indirect method to calculate FCF and CFE and use OWC, then as a result

you have Operational FCF or operational CFE."

Ok, you took out cash from working capital but added it back when you define Operating FCF,

since your Operating FCF include (note: I use CB as a reference, since your book supports CB):

NCB (before debt and equity financing) - tax on interest income (to purify your Operating FCF)

+/- changes in CRO (this is the cash needed to support daily operations).

That's one thing.

IVP:

What we try to do is to reconcile the FCF and the CFE with the OFCF and OCFE.

Karnen:

Back to Operating CFE, does this mean that Operating CFE = Operating FCF + TS - CFD ?


Page 35

IVP: YES

Karnen:

Note: Sorry, I always avoid using "direct" or "indirect method" as I believe Cash is Cash,

regardless how we are going to derive it. That's accountants' way of working out the cash flow

statement (cash flow from operating section).

IVP:

YES. Cash is cash. That is true for us, not for those that use Potential Dividends. For them

Cash is not cash because part of it is "distributed" as Potential Dividends, but they still keep the

whole cash in the BS.

Listen, my dear Karnen, all this mess comes from those who use Potential Dividends (a.k.a

Operating Working Capital), not from us! The problem is that most users blindly use the recipe

for FCF and CFE and assume Operating Working Capital and don't realize which the

implications of doing that are. The indirect method was very good when they didn't have the

possibility or the desire (or decision) to construct the CB. Today with the computational

resources we have we can do it directly.

Karnen:

Hi Ignacio,

Do you happen still keep your Excel files for those Tables shown under Appendix C of Chapter

7? I am a bit difficult to follow the figures displayed there. I don't know why you put all these

examples into Appendix C, though I see the examples are quite critical, since they demonstrate

that it is critical to put marketable securities (including its interest income and tax effect) as part

of total FCF or CCF.

If you have those files, really appreciate it if I could have them as I really want to understand

what you guys meant it in that Appendix C. Some readers might skip Appendix C, thinking it is


Page 36

just an additional material, which might or might not be that important. But to me, it is important

subject, since it will impact the levered value of the firm.

IVP:

Dear Karnen,

Let me try and find out where they are. I am sure they are somewhere. As soon as I find out I

will let you know.

Yes, the idea there is to show that in that case, there is an overestimation.

Karnen:

and one thing more...I am totally confused...

CFE - what items you are going to include it? Is it "real cash" flowing to the equity holders in

each period of forecast?

IVP:

I explained it in my last message. That is a hodge podge of items that makes them

indistinguishable! CFE comes from the bank account, first. If you see it in the CB, the same. It

comes from operational income, excess cash return, less a lot of items as AP paid, interest,

principal, and even investment of cash excess, etc. BUT CFE is defined out of policies: how

much of Net income we are going to distribute? How much of excess cash (or retained

earnings) are we going to distribute?

Karnen:

CFE - those items should be "sustainable" meaning "not one-off"(return on marketable

securities might be interpreted, not "sustainable", or "sustainable"?)


Page 37

I will send you one paper about this as enclosed (published in the Journal of Applied Corporate

Finance, Morgan Stanley, “Measuring Free Cash Flows for Equity Valuation: Pitfalls and

Possible Solutions”)

IVP:

Sustainability reminds me a perpetuity. If I distribute something that is occasional in year n

should I exclude that form CFE? For instance, the firm sold retail of paper (if they process books

or note pads...) That contributes to Net Income. Should I exclude that from the payout policy? I

would say NO!

I will read the paper}

Karnen:

Hi Ignacio,

I go through quickly on Appendix C of Chapter 7 since I am not too sure whether I could follow

all the figures shown in those Tables. But the idea is what discount rate are we going to use for

"changes in marketable securities +/- interest income and tax on interest income"?

Well, we have three choices:

kd?

ku?

ke?

or even rf (risk free rate, for example, short-term or long-term government bond)

If we put it as part of FCF, then it is the WACC as the discount rate


Page 38

If we put it as part of net debt (debt - changes in marketable securities), then the discount rate is

kd?

Is that possible, you help me elaborate it a bit so that I could grasp what you guys want to

convey in that Appendix C?

IVP:

Dear Karnen,

I would put that in a simple way:

When we define CFE and FCF we derive them from the CB (a direct method). CFE is what

appears to be distributed to shareholders. No discussion on this. That CF doesn't have

increases in cash or marketable securities. It does have the return on investment and has the

actual principal and interest payments to be paid to debtholders. We discount what we distribute

(actually distribute) to shareholders and debtholders with Ke and Kd respectively, as it should

be. As said when justifying Ke as discount rate for TS, shareholders don't even realize what is

inside the check they receive. And they receive TS and return on short term investments,

dividends, repurchase of stock, etc..

As we don't net out debt with cash, we don't have any problem on which discount rate to use.

Your questions should be addressed to those who include in the FCF and CFE items that are

not distributed but that are Potential cash flows or dividends (that in fact are listed in the BS).

They simply discount those potential Dividends with WACC and Ke. We don't have to answer

those existential and difficult questions!

Best regards

Karnen:

Dear Ignacio,

You said:


Page 39

“When we define CFE and FCF we derive them from the CB (a direct method). CFE is what

appears to be distributed to shareholders. No discussion on this. That CF doesn't have

increases in cash or marketable securities. It does have the return on investment and has the

actual principal and interest payments to be paid to debtholders. We discount what we distribute

(actually distribute) to shareholders and debtholders with Ke and Kd respectively, as it should

be. As said when justifying Ke as discount rate for TS, shareholders don't even realize what is

inside the check they receive. And they receive TS and return on short term investments,

dividends, repurchase of stock, etc..”

So you say that CFE (this will include dividends, stock repurchase, capital injection, return on

marketable securities, and TS) all be discounted at Ke? It sounds to me very logical, since from

the equity holder, he/she only thinks about Ke.

However, a couple of stuffs:

Dividends, stock repurchase, capital injection - these items have real cash flow flowing to the

equity holders' pockets (I use real cash since you touched that above, "actually distribute" and

not "potential").

IVP: YES!

Karnen:

The way you discount with Ke, mix up items that actually distributed and potentially distributed

(return on marketable securities might not always distributed to the equity holder).

I need to clear out my confusion about this.

IVP:

Well, precisely it is not crystal clear where CFE comes from. For instance, it is clear to me that

CFE = FCF + TS - CFD. This means that SH receive the TS the firm earned from the financial

expenses. Income from marketable securities goes into the cash inflows of the firm. They put

that in the bank account and don't use a special account to keep TS, investment returns, etc. All


Page 40

of them go to the bank account., Once there could you tell me what is what? I can tell you by

sure that in the bank account where the check for SHs comes, there is a mix of everything (loan

received from the bank, interest received for excess cash, AR paid MINUS and other bunch of

items). There is a saying that my cash and your cash look alike and we cannot distinguish them.

So be careful. :-)

Karnen:

So can I say (I looked again at how you build CB, especially CFD and CFE) that:

CFD and CFE consist of ACTUAL CASH FLOWS FLOWING TO DEBT HOLDERS AND

SHAREHOLDERS.

FCF + TS = CFD + CFE

IVP: YES, EXPECTED as any forecast!

Karnen:

Looking at the above equation, then the easiest way to do the valuation, is identifying the

ACTUAL cash flows to Debt Holders and Shareholders (Credit side of the above equation), and

TS, that's all. Don't worry too much about how we are going to define or to include which items

into FCF.

IVP:

YES! That's all.

Karnen:

However, if the above conclusion is correct, I did remember you are saying that FCF is not the

same with actual cash flows, since FCF will include opportunity lost (which has no actual cash

flow, but has implication into the FCF). How to reconcile the above equation?


Page 41

IVP:

Well, we do say that the direct and indirect method should match. And how they match, sticking

to what the financial statements say. For instance, working capital is Current assets - current

liabilities (except short term debt and current part of LT debt). THAT'S all, my dear friend.

I don't know what you mean I said about opportunity cost! What are you talking about? What I

said is that funds in cash in hand and in marketable securities destroy value and that has to be

reflected in the valuation. That is taken into account when you use the WC as defined with CA

and CL as above. NOT when you use the OWC that assumes as if charges were distributed to

SH.

Karnen:

FCF = CFD + CFE - TS (all three items are actual cash flows) +/- opportunity lost?

IVP:

No idea of opportunity lost. Cash flows are Cash that flows!

Karnen:

From what I read your reply to me, we DON'T HAVE TO WORRY, HOW THE MONEY

SOURCES that flow into CFD and CFE. Is this correct?

IVP:

YES. That money comes from the bank account! Of course that at the end of the day you can

see in the CB where it came from (AR, cash in hand and marketable securities from previous

periods, even, it could be from a loan received from the bank, etc.), Remember, ALL bills and

coins look the same once they are in the box or in the bank.


Page 42

Karnen:

Opportunity lost, for example, if the project use the vacant land owned by the company, then

that "rental cost" should be factored into the FCF.

IVP:

Dear Karnen,

I see what you mean. You have two options: either assign a rental and no investment at t=0 or

you have the investment at t=0 and no rental it is a problem of calculating NPV.

The problem is if the PV of rental fees is different from actual value (you have to grant that the

"value" of the land, building etc. is updated, say, by a realtor).

In any case you have an investment, you might pose this problem. Assume you buy an

equipment to generate X CFs. Then you wish to know if it is a good investment. What do you

do? Usually you forecast the CFs and discount them to t=0 and subtract the value of the

investment. THAT is the typical approach of ANY textbook on project appraisal.

You might do it differently. As you suggest. Assume you don't have the facilities and assign to

the project a rental fee for those facilities and that is it.

However, what is the BS showing? That you have fixed assets and your CFs says you don't.

What is the CFs showing? that you have some outflows that are not listed neither in the CB, nor

in the IS. And then problems start because in the CFs you say something and in the financial

statements you are showing something different. And what you do with the Depreciation

charges? And Taxes? Are you deducting the rental fee and not the depreciation charges? and

so on.

I think that the Golden Rule is keep consistency among the 3 financial statements and the CFs.

When you start to change what happens every day, you are prone to make mistakes.


Page 43

Karnen:

Dear Ignacio,

Thanks for the reply. Yes I know it will sound a bit complicated.

What sticks to my head, is FCF + TS = CFE + CFD. We focus on 'real' cash flows, right? that

going to Debtholders and Shareholders...Easy like ABC....but once we include the "opportunity

lost" then this are not "real" cash flows anymore. That additional rental or whatever opportunity

lost/cost, needs financing, and most of the time, we are going to assume, Shareholders will

inject "cash" (for spreadsheet model exercise only) into the project, though we know, they don't,

since it is only "opportunity cost/lost".

Then, the above equation needs to be modified to become:

FCF = CFE + CFD - TS +/- Opportunity Cost/Loss (and all its consequences).

Do you agree with me?

One more,

I need to go back to Appendix C of Chapter 7 tomorrow.

You said that the purpose of Appendix C is to show that we could over-value the firm value.

Since I still have a problem to follow the figures displayed there, then I need to use my logic.

FCF = CFE + CFD - TS

We include the changes of marketable securities and interest income (net of tax) into FCF, and

discount it using WACC. Will this WACC for FCF with marketable securities and interest income

(net of tax) take into account, the weighted average of Kd, Ke, (ke,ku,kd for TS, depending our

assumption for psi) plus interest on marketable securities (going rate for placing the excess fund

into the short-term marketable securities)?


Page 44

In many books, marketable securities will be offset again debt, so we know, FCF will be smaller

than what your book suggests, then how come, we over-value firm value using this approach

while FCF is smaller than your approach (by including it into FCF)?

Thanks in advance.

IVP:

Dear Karnen,

Yes... what to say... I follow what you say, but that creates problems, disguise expenses, lot of

things

That "opportunity cost" is as fictitious as Potential Dividends. Requires no injection from SHs nor

new loan, it is not an expense, is not tax deductible, is not a cash outflow, It is a kind of

unnecessary noise. What is the advantage of that if it was financed, say, from t=0?

Perhaps that is something that my friend Joe likes very much: economic depreciation? BUT you

already depreciated it through an accounting depreciation....

May I suggest that you write a couple of paragraphs saying which are the advantages of doing

that versus the problems it creates. How would you explain that to SHs? Don't they would say,

hey, if there is CFs for supporting that artificial expense, why not increase the CFE and you give

us those funds?

I don't know how to solve that problems and how to explain that to a stockholders and how I

could justify that.

I just remember that we had a case where one of the partners had a terrain. The first idea was

to contribute with it as equity in kind. However, at the end of the day what they agreed was

simply to rent the land. No more. That rent went to the IS, to the CB and that was all. He was

happy thinking he would receive that rent for 20 years. Nothing fictitious. Real outflows. No

problem.


Page 45

Tell me, is that a current practice in your consulting?

Karnen:

Hi Ignacio,

I was grown up with all standard corporate finance textbooks (started with Managerial Finance

by Weston, then in touch with Brealey & Myers, Damodaran, Stephen Ross, etc. etc.) and they

all taught me the same stuffs...opportunity costs are critical and they should be included in the

estimation of cash flows on an incremental basis. The key word is relevancy....each resource

(whether we use or not) has a cost that might be relevant to the investment decision analysis,

even when no cash changes hands. I don't think I could shake them off my head and my

consulting practices. I will stick to that....When more than 3 people say that you are a giraffe,

then you better listen to them (smile)...."The law of mass opinion"..

IVP:

I understand your position. Now, answer me this. If you include opportunity cost in the CFs

when discounting them aren't you calculating the NPV? And yet, I wonder if when you do that

you call that the VALUE of the project. Now, if you include that cost AND calculate the NPV

subtracting the investment, aren't you double counting the investment?

Karnen:

Since you touched on the economic depreciation, the proper words are EXPECTED economic

depreciation.

IVP:

Yes, of course.


Page 46

Karnen:

See paper written by Zvi Bodie in "Compound Interest Depreciation in Capital Investment"

(Harvard Business Review, 1982). Good articles about using this kind of depreciation, but still

the firms have not adopted it yet... So, sorry, it won't work in the past, and I don't think it will

work in the future.

Then, back to my hellish confusion.

I will not start with CFE and CFD anymore since I know they might not be 100% cash once we

include all those opportunity costs, allocated overhead costs from the headquarter, etc. etc.

IVP:

Then, what are you planning to do?

Karnen:

Then I have no choice to get back to FCF...I do hope you are not shouting out to me to stop

(smile)...

IVP: Never!

Karnen:

FCF + TS = CFE + CFD. We do know now, they are not purely 'cash" as you suggest.

IVP:

If you include those opportunity costs, you are right. Now you tell me how would you balance

the equation.


Page 47

Karnen:

I will focus on FCF, and need your confirmation, just yes or no (I know you are going to hate me,

but I will accept that to keep me mentally healthy (smile))

IVP:

Keep you healthy! That is the most relevant issue.

Karnen:

FCF = EBIT (1-T) + Depreciation +/- Changes in Working Capital (I will include CRO, or cash

for operating activities) +/- Changes in Capital Investment

+/- Changes in Marketable Securities

Do you agree with me that FCF that you are suggesting in your book is as put above?

Note: Interest income on the marketable securities and its tax are included in EBIT (1-T), so we

just add the term of changes in marketable securities into the "traditional FCF" (as taught in

many valuation and corporate finance textbooks).

IVP:

Yes. the only thing is that I have separated EBIT and interest income. Now in the Spanish book

what we do is to Have explicitly EBIT+OI (and from there we define the TS. Remember the

segmented equation I mentioned before?) and based on that, we calculate Tax.

My question is what is included/excluded from Working capital. In our definition of FCF WC is

CA - CL (excluding debt). I see that your WC includes CRO BUT not marketable securities. Are

they included outside the WC? when you say "+/- Changes in Marketable Securities"

What we do is to subtract change in WC and that is it. NO +- WC change. It is -WC change.


Page 48

Karnen:

If you agree with me, then, that will make my life a bit lighter.

IVP:

It seems to me that what you do to derive FCF is the same we do and you don't have Potential

Dividends. Do you?

Karnen:

Once we agree on FCF, without TS, we will WACC (adjusted or traditional on FCF) as the

discount rate.

IVP:

OK. Agree, however, do you use constant wacc or changing wacc according to leverage?

Karnen:

If + TS, then we will use WACC (adjusted or traditional on CCF) as the discount rate.

IVP:

If +TS you have CCF and the WACC is different, but might be constant if inflation is constant,

assuming the firm doesn't change the business objective.

Karnen:

Follow?

The above approach will make us disregard the "actual" or "market" return on the marketable

securities, since we bundled it into FCF figures. We care no more, whether it is value destroyer

or value creator.


Page 49

IVP:

Agree. That is not a relevant discussion. We know that cash in hand has NPV<0, but that is

another issue. That negative NPV is bundled in the total value. And you are right, although cash

in hand is a value destroyer, by itself, it could be a value creator for other reasons in the future. I

don't care about that because it is a "cost" that should be assumed by the firm. My problem with

that is when cash in hand is assumed wrongly to be distributed to SHs.

Karnen:

Make sense?

IVP:

Yes. Until now what we say and what you do are in line. We are in agreement.

Karnen:

I will continue this in next email, since this will bring us to more than one alternative. Remember,

business will be TOO SMALL to have only one alternative, let alone, this is projection, nobody

(only God) will know what is going to happen tomorrow....let alone, 5-10 years

projection/forecast period.

IVP:

Sure, sure.

Karnen:

Thanks and appreciate in advance your response.

IVP: OK


Page 50

Karnen:

Hi Ignacio,

What is the paper that you mentioned about Joe and Nick? I took a look on ssrn.com and there

are some papers written together by Nick and Joe, but I am not too sure which one that you are

referring to?

IVP:

Tham, J.& Wonder, N. X., (2002) Inter-temporal Resolution of Risk: the Case of the Tax Shield

(April 2002).

Available at SSRN: http://ssrn.com/abstract=308039 or http://dx.doi.org/10.2139/ssrn.308039

Tham, J. & Wonder, N. X., (2001) Unconventional Wisdom on PSI, the Appropriate Discount

Rate for the Tax Shield (September 2001). Available at SSRN: http://ssrn.com/abstract=282149

orhttp://dx.doi.org/10.2139/ssrn.282149

Karnen:

I have downloaded the papers you wrote together with CA Magni regarding the Potential

Dividends. I have no problem with Potential Dividends. It is all about assumptions, and will vary

from one company to another company. As I put in my previous email, the management has at

least three options:

IVP:

Yes, see previous message I just sent.

Karnen:

1) Keep it under the company's vault - but this will bring two another alternative, interest income

stays with the company, or be distributed as dividends to the shareholders.


Page 51

2) go straight to service debt.

3) go straight to be distributed as dividends.

IVP:

Listen, if you read the model I sent when we were discussing plugs, you will find there the

following:

There is a payout policy that is used to calculate dividends out of Net Income

There is a distribution of excess cash policy that defines how much of the investment in

marketable securities to be redeemed this year will be distributed as extra dividends or

whatever you with to call that.

Karnen:

Though you mentioned about that it is not easy to identify the source of the money once they

flow into the company's bank account, from my experience, the company's treasury will surely

know that.

IVP:

Yes, see above. The problem is that the origin of the distribution of dividends and extra

distribution is difficult to say where they come from. Could you tell me where Net Income comes

from? Sales?, AR?, loans? is difficult to say and I don't care. What we can do is what I

explained above of what I use to define CFE (dividends, from NI and extra dividends from

excess cash recovered from marketable securities investments. That's all I can say on that

issue.

Karnen:

They will keep track the company's in-flows and out-flows. Though it is not possible to track 1

cent to 1 cent, but on overall, we do know from where the money that will be used to service the

debt or pay it as dividends to the shareholders. It will be too naive to say, the company


Page 52

management does not know. I don't think there will be any management to say like that, that

they don't know (strange sounds to me?).

IVP:

Well, yea! THAT is what you do with the CB! You include some policies there. As I have

mentioned, the distribution policy (dividends and extra dividends), how much debt I decide to

have (defining how much debt I use to cover deficits or if I use new investments from SHs)

Karnen:

What do you think?

IVP:

I say what I think. See above.

Karnen:

Dear Ignacio,

Back to excess cash or marketable securities.

IVP:

OK fine.

Karnen:

There will be at least three assumptions that we build into the forecast:

First, keep it on the debit side of the balance sheet (many companies nowadays are doing this,

for example, oil companies, Google, Apple, Microsoft, etc. Note : many studies have been there

to explain why the companies keep hoarding cash in their vault). So I would say, as per my


Page 53

reading of all those studies, the excess cash kept in the marketable securities ARE NOT VALUE

DESTROYER...

IVP:

OK, if that gives you peace of mind, then I agree. No problem. The only thing I ask you to agree

with me is that funds that are kept in the vaults or in hand, cannot and shouldn’t be assumed as

distributed. Agree?

Karnen:

We cannot use interest on marketable securities (which is lower than the cost of debt or cost of

equity) to say that as the interest on m/s is lower, then they are value destroyer. There are so

much advantages to keep the cash on the debit side of the balance sheet. The capital market is

not perfect, if the company needs money, they cannot just go the creditor or shareholder to get

the money needed to support their business plan or expansion. There are always costs...and

the costs, believe me, get higher and higher.

IVP:

OK see above.

Karnen:

We need to factor into this into saying whether the marketable securities is value destroyer or

creator. The management is not stupid, and I have seen many funds from IPO flowing into the

company's bank, and the management keeps there for a couple of months.

IVP:

Forget that qualification as said above.


Page 54

Karnen:

If this is what we build into our forecast, then FCF will include the changes in the marketable

securities.

IVP:

Agree. That is my argument. We agree!!!

Karnen:

Follow?

Second, we believe in the Free Cash Flow theory, then any excess cash will not be good for the

shareholders, they will push the management to keep the cash as low as possible. Is this

wrong? No, many papers had been issued to explain away that FCF theory does exist.

IVP:

Dividend policy is one of the unsolved issues in finance.

Sure that SHs (= Shareholders) will push that. They prefer to receive their dividends and not

leave them in hand or in marketable securities. At the same time as you rightly say, there must

be powerful reasons and arguments to keep cash in the vault. The only thing I ask when

constructing CFs is to be consistent with the policies the firm adopts regarding the use of cash.

If cash is in the vault, that is it. What we cannot do is to say that it is in the vault AND at the

same time say that it is distributed. I hope you agree with me on that.

Karnen:

So we have two options:

The forecast could set a minimum balance of cash for operations, and any excess fund will go

straight to reduce the debt balance. In practice, the management has an arrangement with the


Page 55

bank, this is what called "sweep account", and any excess above minimum balance will go

straight to pay the debt owed to the bank. This could be done in a couple of minutes, automatic

request.

IVP:

If it goes to reduce debt, THAT should be shown in the BS AND in the CB. And as a

consequence, no more interest paid. Agree?

Karnen:

If this is what we project (read : assume), then: FCF will not include the changes in the m/s, and

we need to purify the EBIT (1-T) by taking out the interest income and its corresponding income

tax.

IVP:

NOT taking out interest. Simply if I pay debt, then no debt and no interest. That simple.

Karnen:

This will bring complication. Since we know, this is NOT FREE, all those items (changes in m/s,

interest income and income tax) should go somewhere.......where they are going in the equation

you gave me:

FCF + TS = CFE + CFD

IVP:

Listen, this is not MY equation. THAT and the similar symmetric equation for value (VUn + TS =

D + E) comes from M&M (1958/1963).


Page 56

Karnen:

I guess it will go to the CFD. If this is the case, then CFD is NET CFD (= Debt service (principal

and interest expense) LESS the changes in marketable securities, interest income and income

tax).

IVP:

If you are consistent in the financial statements, no need for adjustments and messing up the

issue. If the decision is to repay debt, then you do that and it will be reflected in the BS and in

the CB and hence stop paying interest.

Karnen:

But this will complicate what discount rate for NET CFD, since now the return on debt holders

got mixed up with the return on marketable securities (which is lower). I suggest using the

weighted average of the kd (after tax) and interest on marketable securities (after tax).

IVP:

See above. I will say the same: consistency

Karnen:

Third, excess funds will be used to be distributed as dividends....FCF theory supports this as

well. As this is dividends and they are part of capital return, then we will be safe to use ke in the

WACC.

IVP:

Yes. See my previous message where I explain how you define dividends and extra distribution


Page 57

Karnen:

I will make things a bit complicated, by referring to the paper that I gave it to you yesterday. That

paper, said that interest income on the excess fund belongs to the shareholders, and it is

sustainable.

IVP:

Agree. BUT I cannot s*** that making adjustments. IF I use a policy in the CB to distribute any

excess cash including interest and capital, do that. However, if you only decide to distribute

interest, well, you construct the model that way and distribute ONLY interest received. You

model what you wish the firm does.

Karnen:

So we have two choices now:

Marketable securities could be assumed to stay with the company, meaning it is part of FCF,

however the interest income on the marketable securities could be paid out as dividends.

IVP:

If marketable securities remain in the firm, they cannot be in the FCF. Remember, the firm is

more valuable if you distribute more to SHs, unless you have some strategic investments that

will generate very large CFs in the future. ALL that is or might be included in the model. It is a

matter of handling xls.

Karnen:

Follow?

If this is what WILL HAPPEN, then


Page 58

FCF = EBIT (note : inclusive of interest income) * (1-T) - Interest Income (1-T) + Depreciation

+/- changes in the working capital (note : working capital includes minimum cash balance for

operating activities) +/- capital investment +/- changes in the marketable securities.

IVP:

Listen, I think adjustments ad-hoc should not be made. Include whatever you wish in a policy in

the model and FCF recipe will be the same always.

Karnen:

FCF (as defined above) + TS = CFE (inclusive of after-tax interest income) + CFD

CFE will be discounted at Ke (no need to do the weighted average of ke and interest income on

m/s after tax, since it is distributed as dividends).

IVP:

YES, CFE ALWAYS should be discounted with Ke!!!!

Karnen:

Make sense?

OK, I am tired now...need to move to my works...

Really appreciate exchanging opinions with you...

IVP:

Well, noted I am tired. The has been long, but I couldn't go to bed without answering your

messages.


Page 59

Karnen:

Hi Ignacio,

Sorry, can you just explain a bit, what do you meant with Potential Dividends included in FCF? I

have not got a chance to read three papers you sent me before about Potential Dividends.

What I would like to say, why we call it "Potential Dividends"..in financial valuation, all is about

ASSUMPTIONS, where we want to put it...Some excess cash may go to pay the loan

immediately (that's easy, we just have the contractual arrangement to do this with the banker),

or go straight to pay the dividends (the shareholders will definitely love our spreadsheet) or we

keep in the marketable securities (as many big companies are doing now)...

I believe the key message of your answers:

“If marketable securities remain in the firm, they cannot be in the FCF. Remember, the firm is

more valuable if you distribute more to SHs, unless you have some strategic investments that

will generate very large CFs in the future. ALL that is or might be included in the model. It is a

matter of handling xls.”

Yes, this is interesting, I don't think people out there give it a thought about marketable

securities in and not in FCF. Mostly people just assume away that this "excess cash" be

distributed to shareholders or paid to creditors, though in reality, they ARE NOT!

So if the marketable securities or whatever excess cash remain in the firm, then we need to

treat them as "investment in working capital" or some kind of reinvestment. Is this correct?

IVP:

Dear Karnen,

You have answered your question about Potential Dividends! The effect of excluding cash and

marketable securities from the Working Capital is to increase/decrease artificially the CFs with


Page 60

funds that are not actually distributed. As they are not but appear in the CFs, they have been

named Potential Dividends not by us, but by [Aswath] Damodaran and followed by many.

We DO NOT include PD (= Potential Dividends) in the CF. They do. What we do is to watch the

CB and see what is actually expected to be paid to SHs (= Shareholders). That is our CFE! And

that should be the CFE to be obtained by the indirect methods! If you use the so called OWC,

they will be different!

Yes, I use to teach and explain an apparent paradox: the firm is more valuable When you pay

MORE, not when you keep more within the firm. Read a classical paper by Jensen where he

explains the agency cost theory! He says that the problem is to make "managers regurgitate" all

the cash invested at lower cost of capital in inefficient investments.

The idea of the paradox comes from the way we teach basic ideas in time value of money

courses. We wrongly give the idea that CFs is inflows minus outflows! Yes, they are that, but not

ins and outs of the firm, but the DH (= Debtholders) and SHs! And you find them in the CB! Not

in the IS, Nor the BS!

Karnen:

Dear Ignacio,

You said:

“I understand your position. Now, answer me this. If you include opportunity cost in the CFs

when discounting them aren't you calculating the NPV? And yet, I wonder if when you do that

you call that the VALUE of the project. Now, if you include that cost AND calculate the NPV

subtracting the investment, aren't you double counting the investment? “

I don't follow this, can you shed a light a bit, for example, using simple example, or anything? I

don't see why you said "double counting"?

IVP:

Hi Karnen,


Page 61

Assume you have a building or an equipment invested in a project/firm. Then you say you wish

to include the opportunity cost of using it in the CF. Well, Assume that you have defined that OC

as the payments equivalent to that investment at the opportunity cost of capital and use the

function payment of xls and get N payments. And following your teacher who taught you the

idea of OC you include that uniform payments in your CF.

What have you done with that? Just to subtract the value of your investment from the CFs!

Hence what you obtain When You discount back Those CFs is the NPV! Not the PV (the firm

value)! And if on top of that you calculate the NPV subtracting the initial investment, you are

double counting the initial investment: once when you subtract the N payments, equivalent to

the investment at t =0 and again when you subtract it from the false "PV" that included Those

payments!

Am I missing something?

Karnen:

Hi Ignacio,

I am not really following it...(my brain needs coffee to activate - smile)....

IVP: Drink Colombian coffee!

Karnen:

Using your example, suppose the company utilizes the vacant land (that is supposed the owner

could rent it out) for the project...then the market rate of the rental cost should be part of the

CFs...we could either put it as higher initial investment cost (at t=0, if this is required at very

early stage of the project) or later (if that rental cost will continue during the project, then this will

reduce CFs at t=1, t=2, go on...).


Page 62

IVP:

OK, let's follow with your example. Assume that you go to a realtor to value your asset and he

says the same argument you have. He calculates the future rents up to infinity and values those

CFs. Then you say my investment in land is worth $X. You use that as investment at t=0.

Agree? Would you include an opportunity cost (equal to the rent the realtor used to value your

land) in the CFs subtracting them? Assume also that you value the project using 100.000

months and you calculate the PV of CFs net of opportunity cost, would you obtain the PV or the

NPV of the project?

And what would be the result if top of that you subtract the value of your land?

See your paragraph: you say "we could either put it as higher initial investment cost (at t=0, if

this is required at very early stage of the project) or later (if that rental cost will continue during

the project, then this will reduce CFs at t=1, t=2, go on...).". Yes, you include it in one of those

two ways, BUT that is for calculating the NPV not the PV of the firm's CFs!!!!

Karnen:

The way we treat the opportunity cost above have nothing to do with the cost of capital. That

"rental costs" are supposed to be "virtually financed" either by debt or equity. The cost of debt or

cost of equity, I believe will stay the same (unless it is very certain situation, where it increased

the "risk" of the project). The cost of capital is ONLY RELATED to the RISK of the project cash

flows..it's nothing to do with whether the amount of cash flows is higher or lower. The risk here

means that the actual COULD BE DIFFERENT with the forecast...

IVP:

This is not the discussion. Assume you don't know how the realtor calculated the value of the

land. He told you that it is $X and it could be rented at $x per month.

Karnen:

So I don't see why it will be double-counting?


Page 63

Do I miss out something with the way you saw or are seeing?

IVP:

Well, to me the rental for 100,000 months is exactly equivalent to the value at t=0. That is the

reason why I say there is double counting. In terms of NPV it would be equivalent to have $X at

t=0 and $x at t= 1, 2, 3.... In terms of PV you have to exclude $X and/or $x from the analysis.

If you don't have the land you have to include $x per month as a cost and your PV is less than if

you have the land. The NPV in this case will not include subtracting the land, but will include the

value of any other investment you have for executing the project. If you have the land and

include $x as virtual cost of renting it, you will have the same PV as before, BUT you cannot

subtract the $X of the land to calculate the NPV. However, when defining the value (PV) of the

project, you have to explain that it includes (or not) the expense $x. Now, if the case is that you

don't have the land and you really rent the land, it is tax deductible; on the contrary, if you don't

have it and include $x this is not tax deductible, Then you end up with a hodge-podge, a strange

mix of CFs!

Do you see now my concern?

Communication via IM (not completed yet)

Sukarnen Suwanto::

Very quick, i went thru your reply to me re opportunity cost. I don't grasp that 100% the logic

behind the tax deductible makes sense to me seems to me you are the first one raising that to

me but that's not really difficult, we could put the rent net of tax so it will solve the issue re virtual

rent and virtual tax deductible agree?

Ignacio Vélez-Pareja:

Yes, the issue is that you have to construct a mix of real forecasts with taxes and another "fake"

without taxes and those are not real CFs as we already said.


Page 64

Sukarnen Suwanto:

FCF is not "real" cash flows as CB you have put that in your book. Cost of capital is an

opportunity cost concept so apple to apple. Cost of capital IS NOTHING TO WITH CASH

FLOWS BUT the risk.


Tell me about not real cash flow.

Sukarnen Suwanto:

So I don't think we need to emphasize that FCF should be real cash flows flowing to the

shareholders or debtholders. They could get it today or expect someday will realize that's why it

is called "VALUE" and not "PRICE" hope you don't mix up that

It is not like you go to the market you get what you see so I am ok with mixed "real" and "virtual"

cash flows. It is not about money on the table


Of course that forecasted CFs are not real themselves BUT they are an expectation of real CFs

Sukarnen Suwanto:

Once you said "expectation"...anything that can happen, will happen that is the axiom


Hahaha


Page 65

Sukarnen Suwanto:

If not, we live in a totally crazy world. You might need to read the interview with Bill Sharpe

when he defended his CAPM. If not, there will be no differences in opinion, and THE TRADE

WILL NOT HAPPEN IN THE MARKET. That's the axiom again.

I am not too sure whether I am going to challenge that I live with that axioms. There is no such

called "real". Hope you follow me even your CB


When I say real I refer that they are not Potential Dividends as coined by Damodaran.

OFCOURSE a forecast IS NOT real CFs. They are expected values not in the statistical sense

of the word.

Sukarnen Suwanto:

Real is about PAST TENSE and NOT FUTURE TENSE. Hope you see my "world". I accept that

though I know it's not perfect.


Sure sure. But again, in my context, when I say real I refer that they are going to be received by

debt and/or shareholders. Follow? Again, of course they are not real in the sense they have not

occurred.

Sukarnen Suwanto:

Not always, going to be received --- it's expectation but this will be a whole different discussion.

Bottom line I said in the project valuation we need to include opportunity costs since our

discount rate is opportunity cost anyway.

Apple to apple, but I still try to understand your explanation about NPV and PV, the example

you gave about going to realtor.


Page 66


It makes no sense to discuss this., Both of us know that when we use forecasted numbers they

are not real in the strict sense of the world and that when I say real I refer that they are not fake

as are Potential Dividends. Follow?

Sukarnen Suwanto:

Yes, I follow that...I guess we have discussed that before we put what we assume


Yes yes we assume....

Sukarnen Suwanto:

But still clinging to the reality, the past data and what had happened in the past back to the PV

and NPV stuffs that you put there.


Whatever you decide to put in the forecast. It can be from a crystal ball or from historical data,

whatever.

Sukarnen Suwanto:

Land investment from the realtor is PV figure I believe


Ok


Page 67

Sukarnen Suwanto:

It is not NPV


Back to the issue which are the difficulties in my answer to you?

Sukarnen Suwanto:

The way you explained about PV and NPV

I am trying hard to follow it, the figure from realtor is PV, right? but what's the relevance of that?


Write back on my message and show me where is the difficulty, please

~~~~~~ ####### ~~~~~~


Page 68

Disclaimer

This material was produced by and the opinions expressed are those of FUTURUM as of the

date of writing and are subject to change. The information and analysis contained in this

publication have been compiled or arrived at from sources believed to be reliable but

FUTURUM does not make any representation as to their accuracy or completeness and does

not accept liability for any loss arising from the use hereof. This material has been prepared for

general informational purposes only and is not intended to be relied upon as accounting, tax, or

other professional advice. Please refer to your advisors for specific advice.

This document may not be reproduced either in whole, or in part, without the written permission

of the authors and FUTURUM. For any questions or comments, please post it at


© FUTURUM. All Rights Reserved

Devices & Hardware

A discussion over the book- principal of cash flow valuation