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Discounted Cash Flow Models:The Main Input Factors

3.1 ANALYTICAL BALANCE SHEETS AND FREE CASH FLOW DISCOUNT MODELS

Theoretically, the value of a firm is determined by the value of its assets A financed by debt D and equity E: A = D + E. The value of equity equals the value of assets minus the value of debt: E = AD. Assuming that only one class of common shares is outstanding, the value of one share s can be calculated by the value of common equity E divided by the number of shares n outstanding: s = E/n.

Valuing a company would be very simple if the balance sheet always reflected the fair market value of assets, debt and equity. Unfortunately, accountants preparing financial statements have to follow generally accepted accounting principles (GAAP). US GAAP requires that fixed assets are valued at historical costs less depreciation. The reported book value of property, plant and equipment, often bought years ago, is generally not equal to its current market value. The reported value of current assets is also heavily influenced by accounting conventions. Companies are, for example, allowed to use different methods for inventory accounting. The recognition of intangible assets, including goodwill, trademarks, and patents, is especially problematic. US GAAP, for example, generally requires that research and development (R&D) costs are charged to expenses when incurred while some financial economists argue that R&D costs should be capitalized as intangible assets and be amortized. ...

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