Horsing Around with Clean Surplus Relations
19 Pages Posted: 6 Feb 2001
Date Written: January 2001
Abstract
Researchers continue to "horse race" the Residual Income (RI) model and the Cash Flow (CF) model, with no regard for the underlying assumptions. Recently, Lundholm and O'Keefe (2000) asserted that they have identified an important reason for the discrepancy between the results obtained from the two models, the so-called "incorrect discount rate error". In their paper, it is unclear whether this error with the calculation of the weighted average cost of capital (WACC) can occur in a M & M world because the assumption about a M & M world is not explicitly stated. In other words, they are agnostic about the correspondence between the M & M world and reality.
In this note, I illustrate the use of the WACC in a M & M world and show that the error that has been identified by Lundholm and O'Keefe cannot occur in a M & M world. Thus, it is reasonable to conclude that perhaps the error with the calculation of the WACC only occurs in a non-M & M world, whatever that may be. In addition, I show the estimation of the residual income and CF models with variable returns to levered equity.
Keywords: Multi-period WACC, Residual Income (RI) model, Cash Flow to Equity (CFE), Cash Flow (CF) model
JEL Classification: D61, H43, G31, M40, M46
Suggested Citation: Suggested Citation