Discounted Cash Flow Model

Discounted Cash Flow Model

There have been many surveys of capital budgeting techniques over the past three decades. Although there has been wide acceptance of discounted cash flow (DCF) method, very little is known about the underlying reasons for practice variations in the use of capital budgeting techniques(McDaniel, McCarty et al. 1988). In particular, the extant literature reflects two shortcomings(Chen 2008). First, the free cash flow does not measure value added from operations over a period. It confuses investments (and the value they create) with the payoffs from investments, so it is partly an investment or liquidation concept. Second, in DCF analysis, cash receipts from investments are recognized in periods after the investment is made, and this can force us to forecast over long horizons to capture value. DCF analysis violates the matching principle.

DCF applies when the investment pattern produces positive constant free cash flow or free cash flow growing at a constant rate. DCF applies when equity investments are terminal or the investor needs to "cash out," as in leverage buyout situations and private equity investments: where the ability to generate cash is important(Penman 2007).

Residual Earnings Model

During the past decade, Residual Earning Valuation (REM) has become prominent in the accounting literature. The main reason for REM's widespread acceptance rests on its apparent ability to procure a constructive role for accounting data in equity valuation(Ohlson 2000). Traditional equity valuation, with its emphasis on future cash flow, in contrast suggests a general irrelevance of future earnings and other accounting data.

In Residual Earning Valuation current book value acts as a "valuation-anchor", and the PV of expected future residual earnings reconciles the difference between intrinsic and book value. While this accounting-based valuation formula seems simple enough, the literature also recognizes that GAAP's earnings construct violates clean surplus accounting(Feltham and Ohlson 1999).

Residual Earning is determined by two components. The first is Return on Common Equity and the second is the amount of the book value of the equity investment (assets minus liabilities, or net assets) that are put in place in each period. Firms increase their value over book value by increasing their ROCE above the cost of capital. But they further increase their value by growth in book value that will earn at this ROCE. For a given ROCE (greater than the cost of capital), a firm will add more value with more investments earning at that ROCE.

The residual earnings approach employs the properties of accrual accounting that bring value recognition forward in time. More value is recognized earlier within a forecasting period, and less value is recognized in a continuing value about which we usually have greater uncertainty(Penman 2007).

Advantages:

* Residual earnings valuation recognizes the value in the current book value on the balance sheet, for a start; in addition, value is usually recognized in RE forecasts earlier than for free cash flow forecasts.

* Focuses on profitability of investment and growth in investment, which drive value.

* Incorporates the value already recognized in the balance sheet (the book value); forecasts the income statement and balance sheet rather than the cash flow statement.

* Accrual accounting can be used to create earnings. By recognizing lower earnings currently, a firm can shift earnings to the future. The valuation is unchanged from before. The residual earnings valuation has protected us from paying too much for the earnings created.

* Protection from paying too much for earnings generated by investment. Growth in earnings does not necessarily imply higher value. Firms can grow earnings simply by investing more. If those investments fail to earn a return above the required return, they will grow earnings but they will not grow value.

Abnormal Earnings Growth Model

The AEG model starts with capitalised earnings as an anchor and then adds value by charging forecasted (cum-dividend) earnings by the required return applied to prior earnings. The abnormal earnings growth model adopts the perspective of "buying earnings." It embodies the idea that the value of a firm is based on what it can earn. The AEG model embraces the language of the analyst community. P/E ratios are more often referred to than P/B ratios. On the other hand, the AEG model does not give as much insight into the value creation as the residual earnings model. Firms invest in assets and add value by employing these assets in operations. The residual earnings model explicitly recognizes the investment in assets, then recognizes that value is added only if that return is greater than the required return(Penman 2007).

Abnormal earnings growth is always equal to the change in residual earnings. AEG valuation enforces the point that a firm can not add value from growing earnings unless it grows earnings at a rate greater than the required rate of return. Only then does it increase its P/E ratio. But that is the same as saying that the firm must grow residual earnings to increase its P/B ratio. That is, added value comes from investing to earn a return greater than the required return, and that added value has its manifestation in both growth in residual earnings and growth in cum-dividend earnings over a normal growth rate(Penman 2007).

Section 2

Lyttelton Port Company Limited (LPC) is a port services company based in Lyttelton Harbour, New Zealand. It is the major deep-water port in the South Island. LPC provides marine services, cargo handling and port facilities.

LPC's central location, deep water and proximity to the main population concentration of the South Island give it a strategic advantage. It is the main port call for most shipping lines to unload imports in the South Island. Containers are LPC's main business, with coal and petroleum also significant. LPC container throughput was 259,900 teus in FY09. Of this, 238,700 TEUs were handled through the container terminal.

LPC finalised a long-term contract with Solid Energy in 2002 and Solid Energy renegotiated rail arrangements in late 2004 to enable coal export volumes to resume growth. LPC upgraded the net usable area of its coal stockpile facilities from 2.7 ha to 4.2 ha and upgraded receival and loading plant to increase throughput capacity(spending $30m in FY03/04), enabling Solid Energy to lift export volumes to in excess of 4m tonnes pa. Solid Energy pays an annual facility charge and is charged for each