modelsconsiderbankruptcycostsvery differently,with the
adjustedpresentvalueapproachprovidingmoreflexibilityin
allowingyou to considerindirectbankruptcy costs.To the
extent that these costs do not show up or show up
inadequately inthe pretaxcost ofdebt,theAPV approach
willyieldamoreconservativeestimateofvalue.Thesecond
reason is that theAPV approachconsiders the taxbenefit
fromadollardebtvalue,usuallybasedonexistingdebt.The
costofcapitalapproachestimatesthetaxbenefitfromadebt
ratiothatmayrequirethefirmtoborrowincreasingamounts
inthefuture.Forinstance,assumingamarketdebt-to-capital
ratio of 30 percent in perpetuity for a growing firm will
requireittoborrowmoreinthefuture,andthetaxbenefit
from expectedfutureborrowingsis incorporatedintovalue
today.
Which approach will yield more reasonable estimates of
value?ThedollardebtassumptionintheAPVapproachisa
more conservative one but the fundamental flaw with the
APVmodelliesinthedifficultiesassociatedwithestimating
expectedbankruptcy costs.As long as that cost cannotbe
estimated, the APV approach will continue to be used in
half-bakedformwherethepresentvalueoftaxbenefitswill
beaddedtotheunlevered firmvaluetoarriveattotalfirm
value and expected bankruptcy costs will be ignored.
EXCESS RETURN MODELS
InChapter 4 onforecastingcashflows,weestablished that
growth has value only when it is accompanied by excess
returns—returnson equity(capital)that exceed thecost of
equity(capital).Excessreturnmodelstakethisconclusionto
thelogicalnextstep andcompute thevalueofafirmasa