SSE/EFI Working Paper Series in Business Administration,
Stockholm School of Economics

Abstract: The discounted cash flow model, like other firm valuation models, proceeds in two periods. For each year in the explicit forecast period, there is an individual forecast of free cash flow. On the other hand, all of the years in the post-horizon period are represented through one single continuing value formula, being the steady-state value of the firm's productive assets at the horizon. Continuing value is typically derived by applying the Gordon formula to a simple extrapolation of free cash flow at the end of the explicit forecast period. This paper examines the components of continuing value, in particular capital expenditures and tax savings due to depreciation of property, plant and equipment (PPE). The estimation of two somewhat elusive parameters related to capital expenditures, equipment economic life and capital intensity, is discussed. A further analysis indicates that a substantial part of continuing value derives from cash flow associated with already acquired equipment. Also, the error resulting from assuming steady-state rather than lumpy capital expenditures is identified. Implementation issues relating to the explicit forecast period are also commented on.

Keywords: Valuation; Free cash flow; Steady state; Discounting; Accounting data

23 pages, November 19, 2004

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