Valuing Companies with Cash Flow@Risk

The classic DCF approach to capital budgeting-the one that MBA students in the world's top business schools have been taught for the last 30 years-begins with the assumption that the corporate investment decision is "independent of" the financing decision. That is, the value of a given investment opportunity should not be affected by how a company is financed, whether mainly with debt or with equity. A corollary of this capital structure "irrelevance" proposition says that a company's investment decision should also not be influenced by its risk management policy-by whether a company hedges its various price exposures or chooses to leave them unhedged. In this article, the authors-one of whom is the CFO of the French high-tech firm Gemalto-propose a practical alternative to DCF that is based on a concept they call "cash flow@ risk." Implementation of the concept involves dividing expected future cash flow into two components: a low-risk part, or "certainty equivalent," and a high-risk part. The two cash flow streams are discounted at different rates (corresponding to debt and equity) when estimating their value. The concept of cash flow@ risk derives directly from, and is fully consistent with, the concept of economic capital that was developed by Robert Merton and Andre Perold in the early 1990s and that has become the basis of Value at Risk (or VaR) capital allocation systems now used at most financial institutions. But because the approach in this article focuses on the volatility of operating cash flows instead of asset values, the authors argue that an internal capital allocation system based on cash flow@ risk is likely to be much more suitable than VaR for industrial companies.