Damodaran on Valuation

Chapter 6. Firm Valuation Models

In the preceding chapter, we examined two approaches to valuing the equity in the firm—the dividend discount model and the FCFE valuation model. This chapter develops two other approaches to valuation in which the entire firm is valued, either by discounting the cumulated cash flows to all claim holders in the firm by the weighted average cost of capital (the cost of capital approach) or by adding the marginal impact of debt on value to the unlevered firm value (adjusted present value approach). We also examine a third approach where the present value of excess returns is computed and added to the capital invested in the firm to arrive at firm value.

In the process of looking at firm valuation, we also look at how financial leverage may or may not affect firm value. We note that in the presence of default risk, taxes, and agency costs, increasing the proportion of financing that comes from debt can sometimes increase firm value and sometimes decrease it. In fact, we argue that the optimal financing mix for a firm is the one that maximizes firm value.