Economic Balance Sheet

1
Economic Balance Sheet

• Shows the firm's estimated fair values of all
  items that represent an economic asset and
  economic liability along with the implied value
  of the firm's equity

2

Economic Balance Sheet Cont.

• Differs from a balance sheet prepared under GAAP
• Differs in classification
• Includes all items that are conceptually assets
  or liabilities
• Uses fair values for all items

3
How to Create an Economic Balance Sheet

• Determine a value for core operations
• Estimate the fair value of
• Nonoperating net assets
• Debt
• Other capital claims

4
Five Elements of the Economic Balance Sheet
Core operations - CORE
Nonoperating net assets - NONOP
Debt claims - DEBT
Other capital claims - OCAP
Common equity claims - COMEQUITY
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Five Elements of the Economic Balance Sheet

• 1. Core operations
• Assets and liabilities, central to the basic
  business which cannot be easily separated from
  each other without affecting the cash-generating
  ability of the entity

Eg A - accounts receivable, inventory, PPE,
intangiblesL - payables, deferred revenueA or L
deferred taxes
6
Five Elements of the Economic Balance Sheet
Continued

• 2. Nonoperating net assets
• Assets and liabilities that are not an integral
  part of the companys core operations

Eg A - marketable securities and other
investments, excess cash, unused propertiesL
after-tax present value of contingencies
7
Five Elements of the Economic Balance Sheet
Continued

• 3. Debt claims
• Claims against the firm held by those who have
  loaned it money

Eg short-term debt, long-term debt, capitalized
leases, accrued interest payable
8
Five Elements of the Economic Balance Sheet
Continued

• 4. Other capital claims
• Include all claims on the firm's assets that are
  not common equity and are not included in core
  operations, nonoperating net assets, or debt
  claims

Eg preferred stock, stock options, warrants,
minority interests
9
Five Elements of the Economic Balance Sheet
Continued

• 5. Common equity claims
• The residual claims belonging to the common
  shareholders

10
Economic Balance Sheet Equation
which implies
11
Economic Balance Sheet and Firm Cash Flows
Continued

• May obtain value of a component by
• Forecasting and discounting related cash flows
• Observing market values
• Using the economic balance sheet formula to
  plug one component

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Economic Balance Sheet and Firm Cash Flows
Debt Claims
Core Operations
Debt Service
Free Cash Flow
Other Capital Claims
Firm
Other Capital
Cash Flows
Nonoperating Cash Flow
Dividends
Nonoperating Net Assets
Common Equity Claims
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The Valuation Models
Dividend Discount
Flows to Equity
Residual Income
Free Cash Flow
Adjusted Present Value
14
The Valuation Models Continued

• Given identical assumptions, all five models
  result in the same value for common equity

15
The Valuation Models Continued

• The differences among the models are
• How the computation is done
• What factors about the firm are highlighted in
  the process

16
The Valuation Models Continued

• The Dividend Discount Model
• Forecasts and discounts dividends

COMEQUITY PV(DIVIDENDS)
COMEQUITY means Value of Common Equity
PV means Present Value
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Dividend Discount Model
Debt Claims
Core Operations
Debt Service
Free Cash Flow
Other Capital Claims
Firm
Other Capital
Cash Flows
Nonoperating Cash Flow
Dividends
Nonoperating Net Assets
Common Equity Claims
18
The Valuation Models Continued

• The Flows to Equity Model
• Forecasts and discounts all cash
  flows other than those to the common
  equity holders

19
The Valuation Models Continued

• The Flows to Equity Model

COMEQUITY PV(FCF NONOPERATING CASH FLOW
? DEBT
SERVICE
? OTHER CAPITAL CASH FLOW)
FCF means Free Cash Flow
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Flows to Equity Model
Debt Claims
Core Operations
-
Free Cash Flow (FCF)
Debt Service

-
Other Capital
Firm
Other Capital Claims
Cash Flows
Nonoperating Cash Flow
Dividends
Nonoperating Net Assets

Common Equity Claims
21
The Valuation Models Continued

• The Free Cash Flow Model
• Forecasts free cash flows
• Discounts them at the weighted average cost of
  capital

22
The Valuation Models Continued

• The Free Cash Flow Model

COMEQUITY PV(FCF) NONOP ? DEBT ? OCAP
NONOP means Nonoperating Assets
OCAP means Other Capital
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Free Cash Flow Model
Debt Claims
-
Core Operations
Free Cash Flow (FCF)
Debt Service

Other Capital
Firm
Other Capital Claims
-
Cash Flows
Nonoperating Cash Flow
Dividends
Nonoperating Net Assets

Common Equity Claims
24
The Valuation Models Continued

• The Adjusted Present Value Model
• Discounts the free cash flow at the hypothetical
  discount rate the firm would face if it were
  unlevered
• Adjusts the value for the fact it is levered

25
The Valuation Models Continued

• The Adjusted Present Value Model

COMEQUITY PV(FCF at unlevered cost of equity)
VALUE OF LEVERAGE NONOP ? DEBT ?
OCAP
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Adjusted Present Value Model
Debt Claims
-
Core Operations
Free Cash Flow (FCF)
Debt Service

Other Capital
Firm
Other Capital Claims
-
Cash Flows
Nonoperating Cash Flow
Dividends
Nonoperating Net Assets

Common Equity Claims
27
The Valuation Models Continued

• The Residual Income Model
• Restates free cash flow in terms of book value
  and residual income then
  Discounts the residual
  income and adds it to book value

28
The Valuation Models Continued

• The Residual Income Model

COMEQUITY BV(CORE)
PV(RI from CORE)
NONOP ? DEBT ? OCAP
BV means Book Value
RI means Residual Income
29
Residual Income Model
Debt Claims
-
Core Operations
Free Cash Flow (FCF)
Debt Service

Other Capital
Firm
Other Capital Claims
-
Cash Flows
Nonoperating Cash Flow
Dividends
Nonoperating Net Assets

Common Equity Claims
30
The Valuation Models Continued

• Keep in mind
• Every asset and every liability from the economic
  balance sheet must appear in the valuation
  exactly once

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Summary

• We have learned
• The concept of an economic balance sheet
• How it differs from a GAAP balance sheet

32
Summary Continued

• How to create an economic balance sheet
• How to relate each of the five components of the
  economic balance sheet to the appropriate cash
  flow stream

33
Summary Continued

• An overview of the five valuation models
• That all five of the valuation models produce
  identical results given identical assumptions