Valuation of Unlevered and Levered Firms

Most of the valuation contexts in Corporate Finance, involve the valuation of equity of rm.
Valuation involves only two inputs, estimate of cashows and a discount rate. Depending on the
nancing structure of a rm, the valuation of equity is usually carried out as follows.

1 All-equity rm
Free cash ows refer to the amount of cashows which can be potentially handed out to the
shareholders after meeting all the requirements of a rm. This amount (called F CF ) is dened
as follows for a rm fully funded with equity capital.
F CF = EBIT (1 T ) + Depn. and non-cash expenses (capex + N W C)

(1)

For an all-equity rm, these cashows are to be discounted at the cost of equity, rE (alternatively
rA , which refers to the required rate of return on the assets). The discounted cashows represent
the rm value which is equal to the value of the equity, when debt is zero.

2 Levered rm with constant D/V target

In a rm which employs leverage (partly debt-funded), its cashows are claimed by two entities,
shareholders and creditors. The cashows claimed by the creditors include the interest and
the repayment of debt. The residual cashows are claimed by the shareholders. If you assume
perpetual debt without repayment (only for simplicity), the cashows to the shareholder would
be as follows:
(EBIT Interest) (1 T ) +Depn. and non-cash expenses (capex + N W C)
|
{z
}

(2)

P AT

This cashow, claimed by the shareholders (Equation 2), is called the free cashow to equity
(FCFE ). When the FCFE is discounted at the rE , adjusted appropriately for the leverage level,
it would give the market value of the equity of the rm (not rm value!).

Prepared solely for class room discussion as part of the Corporate Finance course AY 2014-15 by Prof. Joshy

Jacob on February 20, 2015.

The cashows claimed by both the shareholders and creditors in the levered rm would be as
follows:
(EBIT Interest) (1 T ) +Depn. and non-cash expenses (capex + N W C) +Interest
|
{z
}
P AT
{z
}
|
F CF E

(3)

This can be suitably re-written as,

EBIT (1 T ) + Depn. and non-cash expenses (capex + N W C) Interest (1 T )+Interest

|
{z
}
F CF

(4)

Which becomes,
F CF + IT S

(5)

where IT S is the interest tax shelter. If a rm maintains constant D/V target as the leverage
policy, then we know from earlier discussions that the risk faced in earning the tax shelter is
equal to the risk of the free cashows (F CF ) of the rm. This would suggest that the discounting
rates to be applied on both the cashows are the same; rA (why?).
The discounting of the cashows given in Equation 5 would give you the rm value (value of
equity and debt together) in the case of a levered rm with leverage maintained at a constant
D/V. Then, to get the equity value, which is mostly the focus of valuation in corporate nance,
we just need to net out the existing debt value from the rm value.
However, both the methods of valuation (a) discounting of the F CF E at rE and (b) discounting
of F CF and IT S at rA would require the estimate of the debt employed by the rm year to year
during the forecasting horizon. It would be hard to forecast the debt and associated interest
when debt vary along with rm value. Hence, the common approach to valuation of a levered
rm, takes the following steps:
(i) Estimate the free cashows to the rm (F CF ) as given in Equation 1, ignoring the interest
payments (or other debt related cashows, like repayment of debt, in case of non-perpetual
debt). This avoids the need for forecasting the debt and interest cashows. This ignores
the tax shelter earned by the levered rm.
(ii) Discount F CF at a cost of capital which reects the interest tax shelter, which turns out
to be WACC .
However, the approach of discounting cashows given in Equation 5 at rA should give rise to the
same rm value as obtained when F CF is discounted at WACC . We verify this in the following
section.

3 Equivalence of WACC valuation

Let VL0 be the value of a levered rm at time t = 0, F CF1 free cashows to the rm during time
period 1, rD cost of debt, D0 the debt at time t = 0, T the tax rate, and VL1 value of the levered
rm time t = 1.
Then, for an investor holding the levered for one year and selling at t = 1, VL0 would be,
F CF1 + rD D0 T + + VL1
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{z
}
VL0 =

IT S1

(1 + rL )

where rL is the undened discounting rate. When D/V is constant, we know that IT S = A ,
which implies discounting rate for all the cash ows would be rA .
However, when the rm follows a D/V target D0 depends on VL0 , which itself is the object of
valuation. This link between debt and the rm value can be expressed as follows:
Let D0 = VL0 d where d =

D0
VL0

(equal to the D/V ratio). Then,

F CF1 + rD d VL0 T +VL1
|
{z
}
IT S1

VL0 =

Then,

(1 + rA )

VL0 (1 + rA rD d T ) = F CF1 + VL1

Or
VL0 =

F CF1 + VL1
(1 + rA rD d T )

VL0 =

F CF1 + VL1
(1 + rA rD d T )

Or

0
Substituting rA = rE0 VE0 + rD D
,
V0
L

VL0 =

(1 + rE VE00
L

F CF1 + VL1
0
+ rD D
rD d T )
V0
L

which becomes,
F CF1 + VL1

VL0 =

E0
D0

1 + rE 0 + rD (1 T ) 0

VL
VL
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{z
}
wacc

VL0 =

F CF1 + VL1
(1 + wacc)

recursively substituting for VL1 ,

VL0 =

F CF1
F CF2
F CF3
+
+
+ ...
(1 + wacc) (1 + wacc)2 (1 + wacc)3

Hence, discounting F CF at WACC leads to the same rm value estimate as discounting F CF
and IT S at rA .

4 Levered rm with constant perpetual debt

As mentioned already, this leverage policy is somewhat unrealistic. However, the valuation of
the rm becomes very simple. The rm's cashows are F CF plus the interest tax shelter, which
can be easily estimated unlike the case of constant D/V target.
F CF + D rD T
|
{z
}
IT S

Hence, the value of the rm would be:

P V (F CF ) +P V (IT S)
| {z }
VU

where VU is the discounted value of F CF at rA (why?) and P V (IT S) is the discounted value
of IT S at rD . We discount the IT S at rD (which would be lower than rA ) as the interest rate
of the rm's debt reects the risk of earning the tax shelter. Of course, the risk of earning the
F CF is greater, relative to the realization of IT S , which is why we discount it a higher rate; at
rA .