totheownersofthebusiness.Consequently,whenwevaluea
business,wemakeimplicitorexplicitassumptionsaboutboth
whowillrunthatbusinessandhowtheywillrunit.Inother
words, the value of a business willbe much lower if we
assumethatitisrunbyincompetentmanagersratherthanby
competentones.Whenvaluinganexistingcompany,private
orpublic,wherethereisalreadyamanagementinplace,we
arefacedwithachoice.Wecanvaluethecompanyrunbythe
incumbentmanagersandderivewhatwecancallastatusquo
value, orwe canrevalue thecompanywith a hypothetical
optimalmanagementteamandestimateanoptimalvalue.The
differencebetweentheoptimalandthestatusquovaluescan
be considered the value of controlling the business.
Determinants of Firm Value
AsChapters 2 through 6 makeclear,thevalueofanyassetis
afunctionofthecashflowsgeneratedbythatasset,thelifeof
theasset,theexpectedgrowthinthecashflows,andtherisk
associated with the cash flows. If we view a firm as a
collectionofassets,thisapproachcanbeextendedtovaluea
firm,usingcashflowstothefirmoveritslifeandadiscount
ratethatreflectsthecollectiveriskofthefirm’sassets.This
process is complicatedby thefact that whilesome of the
assetsofafirmalreadyexist,andarethusassetsinplace,a
significant component of firm value reflects expectations
aboutfutureinvestments.Reviewingthedeterminantsoffirm
value, there are five key inputs that determine value:
- Cash flows from existing assets. The cash flow from
existing assets is the cash flow left over after taxes and
reinvestment to maintain these assets, but before debt
payments.