12: 55 (6) Unfolding Capital Cash Flow Valuation

CCF method

The capital cash flow is calculated by adding the interest tax shield to

the free cash flow. The interest tax shield is the product of tax rate, cost

of debt and amount of debt. The amount of debt can be an absolute

value or a percentage of the enterprise value.

In this case, using either FCF or CCF will take an approximately equal

amount of effort. But, in the next case, this might not be the case.

Risky debt and a changing capital structure

FCF method

The assumption that the debt is risky in this case adds some

complication to the formula for unlevering the asset beta.

ΒE = (βA – D/V * βD) * V/E

Since the capital structure changes in each period, it is necessary to

calculate the after-tax WACC for each period too. The resulting after-

tax WACCs increase as the percentage of debt decreases in the capital

structure. This is because, with the fall in percentage debt, the benefit of

debt financing reduces. On the other hand, there is no change in the pre-

tax WACC, even with a change in capital structure.

The free cash flows are discounted using the after-tax WACC. Since

every year’s WACC is different, the discount rate for each period is

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calculated as a compounded rate that uses the preceding years’ after-tax

WACCs.