enoughthoughtgoesintotheprocessofmodelchoice.There
isnoone “best”model.Theappropriatemodelto useina
particular setting will depend on a number of the
characteristics of the asset or firm being valued.
Choosing a Cash Flow to Discount
Withconsistentassumptionsaboutgrowthandleverage,we
should get the same value for our equity using the firm
approach(wherewevaluethefirmandsubtractoutstanding
debt) and the equity approach (where we value equity
directly).Ifthisisthecase,youmightwonderwhyanyone
wouldpickoneapproachovertheother.Theanswerispurely
pragmatic.Forfirmsthathavestableleverage(i.e.,theyhave
debtratiosthatarenotexpectedtochangeduringtheperiod
ofthevaluation),thereislittletochoosebetweenthemodels
intermsoftheinputsneededforvaluation.Weuse adebt
ratio to estimate free cash flows to equity in the equity
valuationmodelandtoestimatethecostofcapitalinthefirm
valuationmodel.Underthesecircumstances,weshouldstay
with the model that we are more intuitively comfortable with.
For firms that have unstable leverage (i.e.,they have too
muchortoolittledebtandwanttomovetowardtheiroptimal
ortarget debtratioduringtheperiodofthevaluation),the
firmvaluationapproach ismuch simplerto usebecause it
does not require cash flow projections from interest and
principalpaymentsanditismuchlesssensitivetoerrorsin
estimatingleveragechanges.Thecalculationofthecost of
capitalrequiresanestimateofthedebtratio,butthecostof
capitalitselfdoesnotchangeasmuchasaconsequence of
changingleverageasthecostofequitydoes.Ifyoupreferto