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Strategies & Market Trends : Free Cash Flow as Value Criterion
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To: Pirah Naman who wrote (133)11/4/1997 12:35:00 PM
From: Reginald Middleton  Read Replies (1) of 253
 
<What I am objecting to is your application of discount rate to a company's return on capital. The opportunity cost for the company certainly affects how they decide to employ capital, and from the perspective of a potential owner of the company, certainly affects what cash flows might be realistically anticipated. It does not affect the value of the actual cash flows. Those should be discounted against the opportunity cost of the individual.

The oppurtunity cost of the individual is the oppurtunity cost of investing in XYZ corporation. It certainly does affect the value of the cash flows generated. Lets suppose you have $100 to put into one company. NSCP has a illustrative generic risk figure of 50% (equivalent to the return we would expect to get out of this company in order to be compensated for the risk over and above the risk free rate that we bear to invest in it) and MSFT has a illustrative generic risk figure of 10%. We use this risk factor as a discounting rate to bring the cash flows to thier present value. If both companies generated $50 of cash flows for that year, which investment would be of the highest quality? Hopefully you would pick the one with the lowest risk, which would be MSFT. Therefore, the individual's oppurtunity cost is less for MSFT than it is for NSCP, eventhough the two investments yield the same cash flows. The fact that it generates equivalent cashflows with less risk allows the market to attach a higher valuation to it (when compared to NSCP).

RCM
rcmfinancial.com
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