Managing a Firm's Cash Flow Recovery Strategy

Managing a Firm's Cash Flow Recovery Strategy

Aditya Vikram Rajkumar (Carnegie Mellon University, USA) and Jeffrey Williams (Carnegie Mellon University, USA)
Copyright: © 2012 |Pages: 21
DOI: 10.4018/ijsds.2012010102
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Abstract

Traditional cash flow estimation techniques focus on generating net cash flow estimates period-by-period, which are then discounted by the firm’s cost of capital. While conceptually strong, this aggregation approach can be insensitive to the fine-grained detail so important to managing project cash flows, in particular, that investment returns are always a combination of growth (renewal) and decline (convergence) forces at work over the firm's life. As is demonstrated in this paper, the aggregation problem can be addressed by employing a cash flow recovery period (CFRP) framework, which distinguishes and quantifies the renewal and convergence forces unique to each firm's project cash flows. The benefit of this more fine-grained approach is that it provides an additional level of detail that can be used to manage firm returns.
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Building Strategy Into The Perpetuity Assumption

While different methods of valuation define a firm’s lifecycle differently, they all contain certain drawbacks. The most popular variant of intrinsic valuation, the discounted cash flow method, is characterized by the emphasis it places on the perpetuity part of the valuation. As stated in the first Miller-Modigliani paper, “Dividend Policy, Growth, and the Valuation of Shares” (Miller-Modigliani, 1961), the value of a company is equal to the time discounted summation of all future cash flows generated by that company. The discounted cash flow (DCF) method is made up of two sections. The first is a sum of discounted cash flows over a transient, short time period. The second is the perpetuity value of cash flows generated by the firm as a going concern. One of the drawbacks when using a DCF model is the high percentage of value trapped in the estimate of perpetuity as compared to the transient time period (Mauboussin, 1997).

To calculate the perpetuity value one can either use the Gordon growth method, which uses an adjusted equation derived by Gordon (1959), or the exit multiple approach. In the Gordon growth method, it is assumed that the company will continue to grow at a stable fixed growth rate to perpetuity. Unfortunately, the growth rate assumed is somewhat arbitrary with a single constraint of not exceeding the US economy growth rate. The exit multiple approach attempts to value the perpetuity value of the company relative to a market financial multiple such as Enterprise Value / EBITDA. Unfortunately, this method inherently contains the limitations of relative valuation such as sensitivity to macro economic factors. This significantly reduces one of the major advantages of DCF (being an intrinsic method where value of the company is calculated based on internal factors of the company and not external market conditions). Additionally, DCF valuation does not take into account the cyclic nature of competition, and competitive strategy (Rizzi, 1984).

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