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How to use Capital Cash Flow in valuing a project?
Capital Cash Flow (CCF) is a unique approach to calculate the worth of an investment project. In deciding the value of a project, there are two scenarios in which the CCF approach may be calculated. While there are some basic differences in these two approaches, the result obtained using these approaches are the same. These two scenarios are: fixed debt and fixed debt-to-value ratio.
The CCF method differs from the Free Cash Flow (FCF) method in the sense that in FCF, the interest tax shield is applied in the discount rate rather than on the cash flows of the firm. The approach in which the adjustments of interest are not made in the cash flow is the Capital Cash Flow method.
In the CCF method, the opportunity cost of capital or the discount rate does not depend on the capital structure of the project. For a given rate of risk, the opportunity cost remains the same over the entire period of the project. When fixed debt-to-value ratio is opted, the project's overall value can be calculated using the cash-flowchanges of the project.
CCF Approach under Fixed Debt
In the FCF model of evaluating an investment, the interest shield is discounted at the discount rate. However, the case is different if we consider the CCF approach. In this approach, the cash flows are not subject to interest deduction. Instead, in CCF approach interest shields are applied on the cash flows rather than on interests. Therefore, interest payments are free from adjustment in the CCF approach.
When interest payments are not adjusted while evaluating of an investment project, there are two scenarios in which the cash flows may be adjusted – one in the case of fixed debt and the other, in case of fixed debt-to-value. Although the two approaches look like they would result in different outcomes, the ultimate result is the same in both the cases.
Valuing a Project is Easy When the Debt is Fixed
The opportunity cost of capital or the discount rate of a project is easier to calculate in fixed debt scenario because the opportunity cost or the discount rate does not depend on the project’s capital structure. Instead, the opportunity cost remains unchanged over the entire period of the project. That is why, it is easier to determine the value of the project when the debt is fixed rather than when debt-to-value ratio is constant.
In case of fixed debt scenario, the amount of debt to be repaid remains the same over the entire period, while the debt-to-value ratio changes at the beginning of every year. In such a case, the loans a company sources from the market or investors have to be repaid according to given terms and this is indicated while the loan is sourced. The loans tenure is usually fixed in such a scenario and the firms must be ready with a proper plan to repay them in the mentioned years of the project. Usually, the repayment of loans starts at the end of the first year, but this may be adjusted to be paid at the ending years of the project by the investors too.
In case of fixed debt, the capital structure of a firm changes with changing project value because there is no fixed debt-to-value ratio structure. Therefore, using the calculation of WACC in the Free Cash Flow (FCF) method is not possible in such a case. Moreover, it is complex to calculate CCFs via WACC model, the best and easiest one to do so is to discount the CCFs by opportunity cost of capital to find the value of an investment project.
CCF Approach under Fixed Debt-to-Value Ratio
In CCF method of fixed debt-to-value ratio, the capital structure of the project remains constant. Therefore, the debt value must change and this is reflected in the overall cash flow of the firm. In case of fixed debt-to-value mechanism, the value of CCF would change with changing debt and tax shield. That is why, a dynamic way of measuring the value of a project is more fruitful in the case of fixed debt-to-value CCF mechanism.
In case of fixed debt-to-value ratio, the cash flows are discounted by the opportunity cost of capital. The NPV obtained by doing so is however remains same as the one obtained when the debt is constant in calculating the CCFs. This means that the valuation of an investment project will not be altered whichever way it is calculated. In fact, this is the fact that makes determination of CCFs worthwhile by taking debt-to-value as a constant.
When the debt ratio is kept constant, it is easier to take a route via WACC of FCF to calculate the project value.
The CCF approach needs additional calculations while the debt-to-value ratio is kept constant, as it requires calculating the project value each year. It is therefore cumbersome to gather all the factors every year and apply them to calculate the CCFs. However, when debt is changing, constant debt-to-value ratio method is the only one to correctly calculate the value of CCF. That is why, its importance cannot be ignored.
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