- An Introduction to Capital Structure
- Basic Differences in Capital Structure of Two Firms
- Value of a Firm (Using Operating Free Cash Flows)
- Does Capital Structure Matter?
- Agency Costs of Equity and Debt
- Why Issue of Additional Equity Leads to Share Price Fall?
- What CFOs Consider While Making Capital Structure Decisions?
Value of a Firm (Using Operating Free Cash Flows)
The value of the firm is measured as the sum of the value of the firm’s equity and the value of the debt. Any firm’s objective is to maximize its value for the shareholders. The value of the firm can be measured as the present value of the operating free cash flows over time.
The value of the firm can be expressed using the following formula:
- V is the Value of the firm
- OFCF is the Operating Free Cash Flow After Tax
- WACC is the Weighted Average Cost of Capital
The Operating Free Cash Flow (OFCF) is measured as:
OFCF = Revenue – Operating Expenses – Capital Expenditure
The Weighted Average Cost of Capital (WACC) is measured as:
- re = Cost of equity
- rd = Cost of debt
- E = Value of the firm's equity
- D = Value of the firm's debt
- V = E + D
- E/V = Percentage of equity financing
- D/V = Percentage of debt financing
- t = Tax rate
The expected future cash flows of a firm can also be expressed as a perpetuity. In that case, the firm’s value can simply be expressed as: