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Chapter 10
5.2 More details on cash flows and cost of capital
Free cash flows to equity
Ideally, free cash flows to equity should be used in DCF valuations rather than post-
tax, post-financing cash flows.
Free cash flows to equity are similar to post-tax, post-financing cash
flows, except that they include average sustainable levels of capital and
working capital net cash flow investments over the longer term rather
than this year's figures.
Post-tax cash flows (after financing charges) are often used as an approximation for
free cash flows to equity.
An appropriate cost of capital
In some exam questions, you will be told directly which cost of capital to use.
However, in other cases you will be expected to either calculate or select an
appropriate cost of capital. It is then important to understand the following
relationships:
Use of cost of equity as a discount Use of WACC as a discount rate
rate
WACC can be used to discount free
The cost of equity can be used to cash flows to all investors (i.e. post-
discount the free cash flows to equity tax cash flows BEFORE financing
(i.e. post-tax cash flows AFTER charges) when valuing a project or an
financing charges) in order to value entity (debt + equity value). To find
the equity in a company directly. the company's equity value, the value
of debt would need to be deducted.
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