Notethatthefirmhasnoreinvestmentandnogrowth.Wecan
value equity in this firm by subtracting the value of debt.
Now letusvalue theequity directlybyestimating thenet
income:
Thevalueofequitycanbeobtainedbydiscountingthisnet
income at the cost of equity:
Thissimpleexampleworksbecauseofthreeassumptionsthat
we made implicitly or explicitly during the valuation.
1.Thevaluesfordebtandequityusedtocomputethecostof
capital were equal to the values that we obtained in the
valuation.Notwithstandingthecircularityinreasoning—you
need the cost of capital to obtain the values in the first
place—it indicates that a cost of capital based on market
valueweightswillnotyieldthesamevalueforequityasan
equityvaluationmodelifthefirmisnotfairlypricedinthe
first place.
- There are no extraordinary or nonoperating items that
affectnetincomebutnotoperatingincome.Thus,togetfrom
operating to net income, all we do is subtract interest
expenses and taxes.