associatedwithdebt(intheformofhighercostsofequityand
debtathigherdebtratios).Justaswiththedividenddiscount
modelandtheFCFEmodel,theversionofthemodelused
will depend on assumptions made about future growth.
Underlying Principle
Inthecostofcapitalapproach,webeginbyvaluingthefirm,
ratherthantheequity. Nettingout themarketvalue ofthe
nonequityclaimsfromthisestimateyieldsthevalueofequity
in thefirm. Implicitin thecost of capital approachis the
assumption that the cost of capital captures both the tax
benefitsofborrowingandtheexpectedbankruptcycosts.The
cash flows discounted are the cash flows to the firm,
computedasifthefirmhadnodebtandnotaxbenefitsfrom
interest expenses.
Whileitisawidelyheldpreconceptionthatthecostofcapital
approachrequirestheassumptionofaconstantdebtratio,the
approach is flexible enough to allow for debt ratios that
changeovertime.Infact,oneofthebiggeststrengthsofthe
modelistheeasewithwhichchangesinthefinancingmix
canbebuiltintothevaluationthroughthediscountraterather
than through the cash flows.
Themostrevolutionaryandcounterintuitiveideabehindfirm
valuationisthenotionthatequityinvestorsandlenderstoa
firmareultimatelypartnerswhosupplycapitaltothefirmand
shareinits success.Theprimarydifferencebetweenequity
anddebtholdersinfirmvaluationmodelsliesinthenatureof
theircashflowclaims—lendersgetpriorclaimstofixedcash
flowsandequityinvestorsgetresidualclaims toremaining
cash flows.