CONCLUSION

This chapter developed an alternative approach to discounted cash flow valuation. The cash flows to the firm are discounted at the weighted average cost of capital to obtain the value of the firm, which when reduced by the market value of outstanding debt yields the value of equity. Since the cash flow to the firm is a cash flow prior to debt payments, this approach is more straightforward to use when leverage changes over time, though the weighted average cost of capital, used to discount free cash flows to the firm, has to be adjusted for changes in leverage. Finally, the costs of capital can be estimated at different debt ratios and used to estimate the optimal debt ratio for a firm.

The alternative approach to firm valuation is the APV approach, where the effect on value of debt (tax benefits minus bankruptcy costs) is added to the unlevered firm value. This approach can also be used to estimate the optimal debt ratio for the firm.