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When we talk about the value of a business enterprise, we are usually referring to the value of the
firm without thinking about its debt. (This idea is similar to talking about the value of a house. The
mortgage loan does not affect the home‟s value.) The business enterprise value is represented by the
left-hand graph. This amount is equal to the values of the firm‟s equity and debt. After subtracting the
value of the debt from the business enterprise value, the resulting amount is the value of the firm‟s
equity. We might want to know the business enterprise value in a sale transaction because many sales
are structured to transfer only a firm‟s assets to the buyer, and it is up to the buyer to raise capital from
investors and/or borrow from lenders. (In an asset sale, the seller would be responsible for paying off
the firm‟s existing debt, usually upon receipt of the sales proceeds.)
We usually think about the debt-free methodology in two steps. First, determine the business
enterprise value based on the firm‟s cash flow. But this level of cash flow should be before any
principal and interest payments on the firm‟s debt. Second, if the firm‟s equity is being valued, then
subtract the value of the firm‟s debt from the business enterprise value.
Alternatively, the direct equity methodology values a firm‟s equity by using the net cash flow after
the firm makes payments on its debt. The result of this method is the value of the firm‟s equity.
The direct equity and debt-free methodologies are summarized as follows:
Cost of Capital