Since most firms do not fall into the neat framework
developedhere(suchashavingonlyonezerocouponbond
outstanding),wehavetomakesomecompromisestousethis
model in valuation.
Value of the Firm
Wecanobtainthevalueofthefirminoneoffourways.In
thefirst,wecumulatethemarketvaluesofoutstandingdebt
andequity,assumingthatalldebtandequityaretraded,to
obtainfirmvalue.Theoptionpricingmodelthenreallocates
thefirmvaluebetweendebtandequity.Thisapproach,while
simple, isinternally inconsistent. Westart with one set of
market values for debt and equity and, using the option
pricing model, end up with entirely different values for each.
Inthesecondway,weestimatethemarketvaluesoftheassets
ofthefirmbydiscountingexpectedcashflowsatthecostof
capital.Theoneconsiderationthatweneedtokeepinmindis
thatthevalueofthefirminanoptionpricingmodelshouldbe
thevalueobtainedonliquidation.Thismaybelessthanthe
totalfirmvalue,whichincludesexpectedfutureinvestments,
anditmayalsobereducedtoreflectthecostofliquidation.If
we estimate the firm value using a discounted cash flow
model, then this would suggest that only existing investments
25 should be considered while estimatingfirm value. The
biggestproblemwiththisapproachisthatfinancialdistress
canaffectoperatingincome,andthusthevaluethatweobtain
by using current operating income may be too low.
Inthethirdapproach,weestimateamultipleofrevenuesby
lookingathealthyfirmsinthesamebusinessandapplythis
multiple to the revenues of the firm we are valuing.