Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

SOLVING THE CIRCULARITY PROBLEM

Modigliani and Miller (1963) established that the value of a company depends on three elements: the unleveraged value of the company, the value of the tax shields resulting from the existing debt, and the negative value created by the potential bankruptcy costs. Surprisingly, with some minor adjustments, one can move a typical DCF valuation formula close to the MM approach by making corporate value dependent on the net present value of the unleveraged free cash flow plus the value of tax shields minus potential bankruptcy costs. In short, from a simple DCF expression, we can derive the following formula (see Appendix 11A for the derivation of this formula):

(11.7)

where

I = net investments (excluding depreciation)6

i = expected yield on debt

Rf = risk-free rate

This approach has two advantages. First, it provides new insight into the MM approach to corporate valuation by splitting corporate value into three parts. The first part is clearly the unleveraged firm value:

The second part is close to a formula for tax shields because the present value of the tax shield is calculated as

(11.8)

This part of Equation 11.7 shows that, in addition to the tax ...