assumptions,theAPVandthecostofcapitalconclusionsgive
identical answers. However, the APV approach is more
practicalwhenfirmsareevaluatingadollaramountofdebt,
whilethecostofcapitalapproachiseasiertousewhenfirms
are analyzing debt proportions.
CONCLUSION
Thischapterdevelopsanalternativeapproachto discounted
cashflowvaluation.Thecashflowstothefirmarediscounted
attheweightedaveragecostofcapitaltoobtainthevalueof
the firm, which when reduced by the market value of
outstandingdebtyieldsthevalue ofequity.Sincethecash
flowtothefirmisacashflowpriortodebtpayments,this
approach is more straightforward to use when there is
significant leverage or when leverage changes over time,
although the weighted average cost of capital, used to
discountfreecashflowstothefirm,hastobe adjustedfor
changes in leverage. The alternative approaches to firm
valuationaretheAPVapproach,whereweaddtheeffecton
value ofdebt (taxbenefits minus bankruptcycosts) to the
unleveredfirmvalue,andtheexcessreturnmodels,wherewe
addthepresentvalueoftheexcessreturnstothebookvalue
of capital invested to estimate firm value.
Inthelastpartofthischapter,welookathowchangesinthe
financialleverageofafirmcanaffectthevalueofitsequity.
WeconsiderboththecostofcapitalandAPVapproachesin
making this judgment.
1 Carriedtoitslogicalextreme,this willpushnetworking
capital to a very large (potentially infinite) negative number.