Damodaran on Valuation

6.5. CONCLUSION

This chapter develops 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 there is significant leverage or when leverage changes over time, although the weighted average cost of capital, used to discount free cash flows to the firm, has to be adjusted for changes in leverage. The alternative approaches to firm valuation are the APV approach, where we add the effect on value of debt (tax benefits minus bankruptcy costs) to the unlevered firm value, and the excess return models, where we add the present value of the excess returns to the book value of capital invested to estimate firm value.

In the last part of this chapter, we look at how changes in the financial leverage of a firm can affect the value of its equity. We consider both the cost of capital and APV approaches in making this judgment.