To: jbe who wrote (21669 ) 5/8/1998 2:04:00 PM From: Chuzzlewit Read Replies (1) | Respond to
jbe, you've done very interesting research on debt:equity ratios. Thank you. The problem with using free cash flow as you defined it is that "needed capital spending" is a very difficult item to quantify unless you have detailed knowledge of the company in which you are investing. For this reason, I much prefer a sinking fund approach. The way this works is simple. Suppose you are analyzing a company with $100 million in 7% debentures, due in 28 years. If you calculate the annual payment required to pay down that debt in 28 equal annual installments you have generated the "sinking fund" number. This way you annualize the cash drain rather than relying on the exact dates of expiry of cash which of course will generate spikes in cash outlays. It is exactly the same calculation as mortgages and consumer loans. We simply treat the debt as requiring self-amortizing annual or semi-annual payments.ceteris paribus . Nevertheless, I believe that this approach gives you the best starting point for analysis. The major reason is that it obviates the dilemma created by your observation that some of the firms with the heaviest debt loads have the best free cash flow. I wonder how well they would fare if those cash flow calculations used a sinking fund approach.
