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What is Capital Cash Flow method?
In Free Cash Flow (FCF) method, the interest tax shield is adjusted in the discount rate which is also called weighted average cost of capital (WACC). The adjustment is not done in cash flows of the firm. We can take an alternate measure to adjust the cash flow where the adjustments are not made in tax shields of the business. This is known as Capital Cash Flow (CCF) approach.
In this approach, interest tax shields are adjusted in cash flows rather than in discount rates. This method of adjusting tax shields in cash flow is known as capital cash flow. In other words, capital cash flow is the Free Cash Flow plus the interest tax shield.
In CCF approach, the opportunity cost of capital or the project's discount rate does not depend on the project's capital structure. Moreover, given the amount of risk a company takes, the opportunity cost remains the same over the entire period of the project. Such an evaluation of the project is easier to apply when we consider fixed debt rather than fixed debt-to-cost ratio.
CCF under Fixed Debt and Fixed Debt Ratio
There are two scenarios in which the Capital Cash Flow approach can be applied −
- Fixed Debt
- Fixed Debt Ratio
In the fixed debt scenario, the project's debt ratio changes but the total debt remains constant. In this scenario, the loan sourced from investors must be repaid in a given number of years. The loan remains fixed, and the repayment terms are indicated to the firm.
As there is no debt to ratio structure, the project's capital structure will change with changing project value. So, we cannot use the FCF method with constant WACC to evaluate the project.
While WACC approach may be used to calculate CCFs, the easiest way to evaluate the project would include discounting the CCFs by the opportunity cost of capital which is secluded from capital structure.
Fixed Debt Ratio
In fixed debt ratio method, the capital structure remains constant.
The debt-to-value ratio stays fixed and we need to determine the value of the project every year to find the amount of debt and tax shields. Thus, a dynamic approach is better when debt-to-value ratio of a project remains constant.
In case of fixed debt ratio, when CCFs are discounted by the project's opportunity cost of capital, the NPV obtained is equal to the one obtained in the FCF approach. Therefore, the value of CCF remains intact in both fixed debt and fixed debt ratio methods.
It is also notable that the better way to calculate the CCF in fixed debt ratio method is to determine the FCF and use WACC policy to determine the CCF.
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