The preceding two chapters examined two approaches to valuing the equity in the firm—the dividend discount model and the free cash flow to equity (FCFE) valuation model. This chapter examines approaches to valuation in which the entire firm is valued, by either 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—the adjusted present value (APV) approach.
In the process of looking at firm valuation, we also look at how leverage may or may not affect firm value. We note that in the presence of default risk, taxes, and agency costs, increasing leverage 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.
The free cash flow to the firm (FCFF) is the sum of the cash flows to all claim holders in the firm, including common stockholders, bondholders, and preferred stockholders. There are two ways of measuring the free cash flow to the firm.
One is to add up the cash flows to the claim holders, which would include cash flows to equity (defined either as free cash flow to equity or as dividends); cash flows to lenders (which would include principal payments, interest expenses, and new debt issues); and cash flows ...