Damodaran on Valuation

6.1. COST OF CAPITAL APPROACH

In the cost of capital approach, the value of the firm is obtained by discounting the free cash flow to the firm (FCFF) at the weighted average cost of capital. Embedded in this value are the tax benefits of debt (in the use of the after-tax cost of debt in the cost of capital) and expected additional risk associated with debt (in the form of higher costs of equity and debt at higher debt ratios). Just as with the dividend discount model and the FCFE model, the version of the model used will depend on assumptions made about future growth.

6.1.1. Underlying Principle

In the cost of capital approach, we begin by valuing the firm, rather than the equity. Netting out the market value of the nonequity claims from this estimate yields the value of equity in the firm. Implicit in the cost of capital approach is the assumption that the cost of capital captures both the tax benefits of borrowing and the expected bankruptcy costs. The cash flows discounted are the cash flows to the firm, computed as if the firm had no debt and no tax benefits from interest expenses.

While it is a widely held preconception that the cost of capital approach requires the assumption of a constant debt ratio, the approach is flexible enough to allow for debt ratios that change over time. In fact, one of the biggest strengths of the model is the ease with which changes in the financing mix can be built into the valuation through the discount rate rather than through the cash flows. ...