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Value of a Firm (Using Operating Free Cash Flows)

CFA® Exam, CFA® Exam Level 1, Corporate Finance, PRM Exam, PRM Exam I

This lesson is part 3 of 7 in the course Basics of Capital Structure

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:

Firm Value (V) = \sum_{t=1}^{\infty }\frac{OFCF_{t}}{(1+WACC)^{t}}

Where:
V is the Value of the firm
OFCF is the Operating Free Cash Flow After Tax
And 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:

WACC = r_{e}\frac{E}{V}+r_{d}(1-t)\frac{D}{V}

Where:
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:

V = \frac{OFCF_{t}}{WACC}
Previous Lesson

‹ Basic Differences in Capital Structure of Two Firms

Next Lesson

Does Capital Structure Matter? ›

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In this Course

  • 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?

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