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Journal of Applied Research in Accounting and Finance

Vol 4 (1) July 2009


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Leases, Debt and Value by Aswath Damodaran

When analyzing or the value of a firm, there are three basic questions that we need to address: How much is the firm generating as earnings? How much capital has been invested in its existing investments? How much has the firm borrowed? In answering these questions, we depend upon accounting assessments of earnings, book capital and debt. We assume that the reported operating income is prior to any financing expenses and that all debt utilized by the firm is treated as such on the balance sheet. While this assumption, for the most part, is well founded, there is a significant exception. When a firm leases an asset, the accounting treatment of the expense depends upon whether it is categorized as an operating or a capital lease. Operating lease payments are treated as part of operating expenses, but we will argue that they are really financing expenses. Consequently, the stated operating income, capital, profitability and cash flow measures for firms with operating leases have to be adjusted when operating lease expenses get categorized as financing expenses. This can have far reaching implications for profitability, financial leverage and assessed value at firms.

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Cost of Capital Estimation in the Current Distressed Environment by Roger Grabowski

The current economic environment has created challenges in estimating the cost of equity capital ("COEC") and in estimating the appropriate overall cost of capital (i.e., the weighted average cost of capital or "WACC"). Since late 2008, new complications have arisen in estimating the cost of capital. Traditional methods typically employed in estimating the COEC and the WACC are subject to significant estimation and data input problems. This paper attempts to address some of these issues and offers some specific recommendations on dealing with these issues. First, U.S. Treasury bond ("T-bond") yields, the typical benchmark used in either the Capital Asset Pricing Model ("CAPM") or the Build-up methods of estimating COEC, were temporarily low for several months, resulting in unreasonably low estimates of COEC as of the important valuation date, December 31, 2008. In the past several weeks T-bond yields have returned to more normal levels. Second, the expected equity risk premium ("ERP"), the rate of return expected on a diversified portfolio of common stocks in excess of the rate of return on an investment in T-bonds, has likely increased as the broad stock market level has declined. Third, because the stock market correction has been heavily concentrated in the financial services sector and in highly leveraged companies, the commonly-employed methods we use for estimating betas, the risk measure in the traditional CAPM, are potentially flawed providing faulty estimates of risk for non-financial and companies with little debt. The result is that at the very time when one assumes a priori that estimates of COEC have increased, the methods we traditionally use to estimate the COEC are providing calculations that imply risk has declined. Fourth, current leverage ratios are likely not sustainable in the long-term for many companies and one needs to consider estimating cost of capital with expected changing capital structures. Fifth, because income subject to income taxes is and will continue to be less than zero for many companies, one cannot automatically use an after-tax cost of debt capital (i.e., multiply the interest rate by one minus the income tax rate) in calculating an appropriate WACC. Sixth, one must always test the resulting cost of capital estimates for reasonableness and not simply apply data or formulas by rote.

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Pre and Post Tax Discount Rates and Cash Flows - a Technical Note by Wayne Lonergan

When discounting pre tax cash flows it is often assumed that discounting pre tax cash flows at pre tax discount rates will give the same answer as if after tax cash flows and after tax discount rates were used. However, this is not the case and material errors can arise, unless both the cash flows and the discount rate are after-tax. Drawing upon a series of analytical examples, common conceptual flaws in discount rate and cashflow stream selection are highlighted. In light of these, it is argued that discounted cashflow analysis should be configured on the basis of after tax cashflows discounted with after tax discount rates.

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