The next two chapters will cover the relationship between debt and value creation. Understanding this relationship is fundamental for the valuation process as well as for the calculation of the cost of capital to be used.
We first introduce the relationship between leverage, opportunity cost of capital, and value in a static context, where cash flow is perpetual and the level of debt is held constant.1 These topics are presented in all corporate finance textbooks. We specifically focus on their implications in the valuation of companies and M&A transactions. We describe two methods that analysts may follow while valuing a company with debt or a debt-funded acquisition. Pros and cons of alternative methods are also highlighted.
The methods of financial valuations currently used are based on the present value of the free cash flow from operations (FCFO) at the average weighted cost of capital. Such an approach results in an adequate solution for the majority of capital budgeting problems. However, it is much less satisfactory in the valuation of companies and acquisitions. In such cases, for the sake of transparency of the estimate, a separate estimate of the unlevered value of the firm and of the value of its tax shields conveys more complete information.
If companies were unlevered, or if acquisitions were just equity-funded, analysts could avoid many technicalities. In fact, the absence of debt would also eliminate ...