Analytical Solution to the Circularity Problem When Using Discounted Cash Flow Valuation (Solución Analítica al Problema de la Circularidad Usando Flujos de Caja Descontados) (Spanish)
Innovar, Vol. 21, No. 42 octubre-diciembre, 2011. (Próximo a aparecer en inglés).
29 Pages Posted: 1 Aug 2010 Last revised: 23 Dec 2011
Date Written: July 31, 2010
Abstract
In this paper we propose an analytical solution to the circularity problem between value and cost of capital. Our solution is derived starting from a central principle of finance that relates value today to value, cash flow, and the discount rate for next period. We derive a general formulation for the equity value, E, the firm value and the weighted average cost of capital, WACC, without circularity.
We furthermore compare the results obtained using these formulas with the results using the Adjusted Present Value approach (no circularity) and the iterative solution of circularity based upon the iteration feature of a spreadsheet. We conclude that all methods produce the same answer.
Note: downloadable document is in Spanish
Keywords: Firm Valuation, Cost of Capital, Cash Flows, Free Cash Flow, Capital Cash Flow, WACC, Circularity
JEL Classification: M21, M40, M46, M41, G12, G31, J33
Suggested Citation: Suggested Citation
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