Consistent DCF Methods for Constant-Growth Annuities à la Modigliani & Miller or Miles & Ezzell

Abstract

In this paper, we develop two complete discounted-cash flow (DCF) frameworks for the valuation of constant-growth annuities and perpetuities. By ‘complete’ we mean that these frameworks allow the valuation of a firm or project by means of different DCF methods, particularly, the equity method, the free-cash-flow (FCF) method, the adjusted-present-value-method, and the capital-cash-flow method. This also requires the derivation of formulas that allow the translation between different required returns, like the required return on unlevered and levered equity, the discount rate in the FCF method, and the required return on the tax-shield. Our paper departs from the two most advocated and mutually exclusive frameworks when dealing with DCF. The first is based on Modigliani and Miller (M&M), where the FCF at different points in time are independently distributed. The second framework rests on the analysis of Miles and Ezzell (M&E) who presume a first-order autoregressive cash-flow process. Some elements of a ‘complete’ framework exist in the literature, but in our opinion, a complete picture has not been developed yet. The contributions of this paper are the following: (1) We develop (or expand) the set of formulas that are required for the valuation of constant-growth annuities and perpetuities; (2) The formulas we develop in this paper are based on a backward-iteration process, which in itself represents a suitable tool for firm valuation; (3) Using a numerical example, we show that the two mutually exclusive frameworks of M&M or M&E achieve very different valuation results; (4) It turns out that the expected returns and the growth rate of the FCF are partly linked, but this relationship is different in the two frameworks; (5) In our numerical examples, we show how the constant-growth annuity or perpetuity, can be integrated with an explicitly planned FCF.