Operating Leverage in CCFP - Investments under Uncertainty

Joachim Kuczynski, 04 February 2023

Introduction

The only correct way to discount cash flows and value an asset is the Component Cash Flow Procedure (CCFP). Hereby each cash flow is discounted with its appropriate risk-adjusted discount rate. All fixed cash flows, that have no market risk and are diversifiable for investors, have to be discounted without additional equity risk premiums. Fixed cash flows include fixed operative costs, R&D, investments and cash flows for fixed expenditures like customer and tooling expenses & payments. In contrast to that contribution cash flows depend on the market development. They must be discounted with rates that include equity risk premiums for the investors. Primarily, contribution cash flows consist of turnover, variable costs and working capital cash flows.

In most cases discount rates for contribution cash flow are based on bottom-up betas and not on historical data. These are averaged equity betas representing an average of similar companys in an industry segment in a certain country or market. But these bottom-up betas take into account all cash flows, contribution cash flows as well as fixed cash flows. Hence these bottom-up betas are not correct to discount contribution cash flows alone. But that is exactly what is required in the CCFP. The content of this post is the derivation of the contribution cash flow beta from the bottom-up industry segment beta.

Derivation

Base for the derivation is the market balance sheet where the value of the asset (project or investment), $V_{asset}$ , is the sum of revenues’ value, $V_{rev}$ , the value of variable cost cash flows, $V_{var}$ , and value of the fixed cost cash flows, $V_{fix}$ :

$V_{asset}=V_{rev}+V_{var}+V_{fix}$

Now we derive in respect to the market portfolio return rate $r_m$ and devide by $V_{asset}$ . The relative change of $V_{asset}$ in respect to $r_m$ is just the beta of the asset, $\beta_{asset}$ , by definition. Hence we get

$\beta_{asset}=\frac{\frac{\partial }{\partial r_m}V_{asset}}{V_{asset}}=\frac{\frac{\partial }{\partial r_m} V_{rev} + \frac{\partial }{\partial r_m} V_{var}+ \frac{\partial }{\partial r_m} V_{fix}}{V_{asset}}.$

The fixed cash flows are independent of the market return rate. That means that the derivation $\frac{\partial }{\partial r_m} V_{fix}=0$ and we get:

$\beta_{asset}=\frac{\frac{\partial }{\partial r_m} V_{rev} + \frac{\partial }{\partial r_m} V_{var}}{V_{asset}}=\frac{V_{rev}\beta_{rev} + V_{var}\beta_{var}}{V_{asset}}$

The betas of revenues and variable costs are the same, $\beta_{rev}=\beta_{var}$ . We get:

$\beta_{asset}=\beta_{rev} \frac{V_{rev} + V_{var}}{V_{asset}}=\beta_{rev} \left( 1-\frac{V_{fix}}{V_{asset}} \right)$

Note that the value of the fixed cash flows is negative, $V_{fix} \le 0$ , and the value of the asset is positive, $V_{asset} \ge 0$ , in ordinary cases. The expression in the bracket becomes $\ge 1$ . That means that the beta of the asset is higher than the beta of the revenues, $\beta_{asset} \ge \beta_{rev}$ . Obviously that is true, because adding fixed costs increases the beta of the asset. This effect is known as operating leverage.

Application in CCFP

The bottom up beta from an industry segment includes fixed costs, it corresponds to $\beta_{asset}$ . Applying the previous derivation you can calculate the beta of the contribution cash flows, $\beta_{rev}$ and $\beta_{var}$ . $V_{fix}$ and $V_{asset}$ are values from the market balance sheet of the averaged industry segment companies. If these values are more or less stable over time you can also take the corresponding figures from the averaged income statement of the industry segment. These data are available in several statistical sources. With $\beta_{rev}$ you can calculate the equity risk premium of the contribution cash flow discount rate and hence the discount rate itself, for instance according to the capital asset pricing model (CAPM). With $r_f$ as risk free rate and $r_m$ as average return rate of the industry segment, the equity return rate is:

$r_E=r_f+\beta _{rev}\left( r_m - r_f \right)$

The return rate for contribution cash flows $r_{rev}$ considering debt $D$ and equity $E$ financing including tax shield effect with constant debt to equity ratio and marginal tax rate $t$ is:

$r_{rev}=\frac{D}{E+D} \left( 1-t \right) r_D + \frac{E}{E+D} r_E$

With that procedure we get the correct discount rate for the contribution cash flows in the CCFP approach.

If there are several contribution cash flows from different industry segments with specific risks, we can do that procedure with each kind of contribution cash flow. In this way we get the appropriate return rate for each kind of contribution cash flow.