debt benefits and costs separately from the value of the
operating assets.
While proponentsofeachapproach liketoclaimthat their
approachisthebestandmostprecise,wewillshowlaterin
thebookthatthethreeapproachesyieldthesameestimatesof
value if we make consistent assumptions.
Inputs to Discounted Cash Flow Models
Therearethreeinputsthatarerequiredtovalueanyassetin
thismodel—theexpectedcash flow,thetiming ofthecash
flow, and the discount rate that is appropriate given the
riskinessofthesecash flows.Welookatdiscountrateand
cash flow estimation in far more detail in the coming
chapters, but lay out the fundamentals in this section.
Discount Rates
Invaluation,webeginwiththefundamentalnotionthatthe
discountrateusedonacashflowshouldreflectitsriskiness,
with higher-risk cash flows having higher discount rates.
Therearetwo waysofviewingrisk.Thefirst ispurelyin
terms of the likelihood that an entity will default on a
commitmenttomakeapaymentsuchasinterestorprincipal
due,andthisiscalleddefaultrisk.Whenlookingatdebt,the
cost ofdebtistheratethatreflects thisdefault risk.Since
interestexpensesaretax-deductible,theafter-taxcostofdebt
will be lower for most firms.
Thesecondwayofviewingriskisintermsofthevariationof
actualreturnsaroundexpectedreturns.Theactualreturnsona
riskyinvestmentcanbeverydifferentfromexpectedreturns;