CHAPTER 6
Firm Valuation Models
In thepreceding chapter, we examinedtwo approaches to
valuingtheequityinthefirm—thedividenddiscountmodel
and theFCFEvaluationmodel. This chapterdevelops two
other approaches to valuation in which the entire firm is
valued,eitherbydiscountingthecumulatedcashflowstoall
claimholders in thefirmby theweighted average cost of
capital (the cost of capital approach) or by adding the
marginalimpactofdebtonvaluetotheunleveredfirmvalue
(adjustedpresentvalueapproach).Wealsoexamineathird
approach where the present value of excess returns is
computed and addedto thecapital invested in thefirmto
arrive at firm value.
Intheprocessoflookingatfirmvaluation,wealsolookat
howfinancialleveragemayormaynotaffectfirmvalue.We
notethatinthepresenceof defaultrisk,taxes,and agency
costs,increasingtheproportionoffinancingthatcomesfrom
debt can sometimes increase firm value and sometimes
decreaseit.Infact,wearguethattheoptimalfinancingmix
for a firm is the one that maximizes firm value.
COST OF CAPITAL APPROACH
In the cost of capital approach, the value of the firm is
obtainedbydiscountingthefreecashflowtothefirm(FCFF)
at theweighted average cost of capital. Embedded in this
valuearethetaxbenefitsofdebt(intheuseoftheafter-tax
costofdebtinthecostofcapital)andexpectedadditionalrisk