Whenaskedtoestimatecashflows,mostofuslookatcash
flowsafterdebtpayments(freecashflowstoequity),because
wetendto thinklikebusinessownersand considerinterest
paymentsandtherepaymentofdebtascash outflows.The
secondisthatitsfocusonpredebtcashflowscansometimes
blindustorealproblemswithsurvival.Toillustrate,assume
thatafirmhasfreecashflowstothefirmof$100millionbut
thatitslargedebtloadmakesthefreecashflowsto equity
equalto−$50million.Thisfirmwillhavetoraise$50million
in new funds to survive and, if it cannot, all cash flows
beyondthispointareputinjeopardy.Usingfreecashflowsto
equitywouldhavealertedyoutothisproblem,butfreecash
flowstothefirmareunlikelytoreflectthis.Thefinalproblem
is that the use of a debt ratio in the cost of capital to
incorporatetheeffectofleveragerequiresustomakeimplicit
assumptions that might not be feasible or reasonable. For
instance, assuming that the market value debt ratio is 30
percentwillrequireagrowingfirmtoissuelargeamountsof
debtin futureyearsto reachthat ratio.Inthe process,the
book debt ratio might reach stratospheric proportions and
trigger bond covenants or othernegative consequences. In
fact, we count the expected taxbenefits from future debt
issues implicitly into the value of equity today.
Will Equity Value Be the Same under Firm and Equity
Valuation?
This firm valuation model, unlike the dividend discount
modelortheFCFEmodel,valuesthefirmratherthanequity.
Thevalueofequity,however,canbeextractedfromthevalue
ofthe firmbysubtracting themarket valueof outstanding
debt.Sincethismodelcanbeviewedasanalternativewayof
valuingequity,twoquestionsarise:Whyvaluethefirmrather