The Cost of Capital Approach

In the cost of capital approach, the value of the firm is obtained by discounting the free cashflow to the firm 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 upon assumptions made about future growth.

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 non-equity 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.

The most revolutionary and counter intuitive idea behind firm valuation is the notion that equity investors and lenders to a firm are ultimately partners who supply capital to the firm and share in its success. The primary difference between equity and debt holders in firm valuation models lies in the nature of their cash flow claims - lenders get prior claims to fixed cash flows and equity investors get residual claims to remaining cash flows.

Versions of the Model

As with the dividend discount and FCFE models, the FCFF model comes in different forms, largely as the result of assumptions about how high the expected growth is and how long it is likely to continue. In this section, we will explore the variants on free cash flow to the firm models.

Stable Growth Firm

As with the dividend discount and FCFE models, a firm that is growing at a rate that it can sustain in perpetuity - a stable growth rate - can be valued using a stable growth mode using the following equation:

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