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Strategies & Market Trends : Gorilla and King Portfolio Candidates
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To: Ausdauer who wrote (2589)6/11/1999 8:57:00 PM
From: Chuzzlewit  Read Replies (1) of 54805
 
Ausdauer, Uncle Frank invited me over to grapple with this question. I don't know that I can answer in 200 words or less (and still be clear) but in the words of Polonius to Laertes, "Brevity is the soul of wit", so let me try to be brief. Wit is more difficult.

Let me start with the simple valuation issue.

I would break the problem down as follows. The valuation of a firm consists of the sum of the discounted value of future free cash flows plus excess cash.

For example, let's assume that we have a company with a capitalized value of $10 BB. Let us further assume that the company has excess cash (meaning cash it could part with without impacting operating earnings) of $1 BB. Obviously, the company could dividend $1BB to shareholders and the company would then be worth $9BB. The $9 BB is the discounted value of future free cash flows.

From a practical point of view that means that excess cash adds value to the firm on a dollar for dollar basis and its value is not diminished by rising interest rates.

Now, let's look at the impact of debt. To the extent that a firm's long-term capital is funded by debt, it is in a riskier position than a pure equity firm because the probability of bankruptcy increases with the greater level of debt. Some financial analysts have argued that the capital structure of the firm is irrelevant to the stock price because the risk of leverage is compensated by the potential added gains. However, I would argue that to the extent that firms have too much debt, increasing interest rates disproportionately punishes them because the risk is perceived to far outweigh the benefits.

I hope this helped.

TTFN,
CTC
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