Free Cash Flow Models, Terminal Values and the Timing of Asset Replacements

This paper analyses the issue of the timing of expenditures in replacing fixed assets within the context of valuing firms using the free cash flow approach. Standard practice amongst both practitioners and academics is to assume a smooth pattern in these expenditures past some future point, and such a pattern is improbable. This paper shows how to correctly address this issue, that failure to do so may induce a valuation error in excess of 50%, and presents an example from a company in which this appears to be the case. In conducting the analysis, it is important to know the current replacement costs of the firm's existing assets, their economic lives and their residual lives. The average values for the last two pieces of information can be deduced from either historic cost or replacement cost valuation of the firm's assets, and average values are sufficient for this purpose. By contrast, the first of these three pieces of information requires replacement cost valuation of the firm's assets, and therefore Financial Statements based upon replacement cost asset valuations are superior to those based upon historic cost valuations