Financial Forecasting and Decision Making

Chapter 4USING FORECASTING TO PLAN THE COMPANY'S CAPITAL STRUCTURE

LEARNING OBJECTIVES

In this chapter, we will examine the effect of debt usage on company value. We will see the relationship between company value and taxes, risk, and bankruptcy. We will then integrate capital structure planning into the forecasting model. After completing this chapter, you should be able to do the following:

•     Recall the optimal capital structure for a firm.

•     Recognize how debt impacts company values.

•     Identify how to determine the value of a firm.

Value of the Firm

 

Where: V   = Value of the firm

     FCF = Free cash flow

     g   = Expected growth rate of the firm's free cash flow

     K_A   = Weighted average cost of debt and equity

This is a type of cash flow valuation model. The basic premise of a cash flow model is that the value of a firm is equal to the present value of the expected future cash flow to be produced by the firm. In their most basic form, cash flow models require an estimate of future earnings, growth, and the cost of capital.

Free cash flows, FCF, are the cash flows left over after the firm has paid all of its expenses and made all necessary investments to keep the firm operating at its current level. By dividing FCF by K_A - g, the cost of capital less the expected growth rate, we are computing the present value of a perpetuity (a perpetual annuity). ...