Cost of Capital: Applications and Examples, + Website, 5th Edition

CHAPTER 3

Net Cash Flow: The Preferred Measure of Economic Income

Introduction

Defining Net Cash Flow

Net Cash Flow to Common Equity Capital

Net Cash Flow to Invested Capital

Net Cash Flows Should Be Probability-weighted Expected Values

Why Net Cash Flow Is the Preferred Measure of Economic Income

Summary

Additional Reading

Appendix 3A: Alternative Measures of Economic Income

INTRODUCTION

Cost of capital is a meaningless concept without a corresponding definition of the measure of economic income to which it is to be applied. Based on the tools of modern finance, the measure of choice for most financial decision making is net cash flow. This, obviously, raises two critical questions:

1. How do we define net cash flow?
2. Why is net cash flow considered the best economic income variable to use in net present value analyses?

Within the income approach to valuation, the most often used methods are the discounted cash flow (DCF) method and the single-year capitalization method. The analyst must choose the method that is most appropriate, given the facts and circumstances surrounding the subject business and available data. Once that decision is made, the analyst must choose between two general frameworks: valuing net cash flows to common equity capital and valuing net cash flows to the aggregate of invested capital.

When net cash flow to common equity is valued, the discount rate should be the cost of equity capital. When net cash flow to invested capital is valued, the discount rate ...