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This example illustrates that with the prudent blending of debt and equity capital, managers can
decrease the firm‟s total cost of capital from 20% to 12.5%. This has the effect of increasing the
current shareholders‟ rate of return. It also has a positive effect on the firm‟s stock price.
The relevance of all of this to valuing a business is that if the goal is to value a firm‟s shares—rather
than the business enterprise value—and the firm does not already have the good blend of debt and
equity capital, a valuation may produce a wrong result unless the debt-free methodology is used.
When valuing stock, the direct equity methodology does not take into account a firm‟s optimal blend
of debt and equity—unless the business already happens to have it. Consequently, the result of the
valuation of a firm‟s shares using the direct equity methodology may result in an incorrect value
because the firm‟s cost of capital is misestimated. However, if the firm already has a good blend of
capital, the direct equity method produces a reasonable estimate of the stock‟s value and is a simpler
methodology.
Victoria‟s analysis shows that Acme does not have the ideal capital structure. Therefore, she
concludes that a debt-free methodology is necessary to properly value Acme‟s shares. This
methodology first estimates Acme‟s cash flows before paying its debt. This level of cash flows will be
higher than a firm‟s net cash flows, which has reductions for principal and interest payments to the
firm‟s lenders. Using this higher level of cash flows produces a higher value. Conceptually, this higher
level of cash flows and value is shared between investors and lenders. This concept was illustrated in
the graphic earlier in this chapter. Once Acme‟s business enterprise value is estimated, then the value
of its debt capital is subtracted, resulting in the value of Acme‟s equity.
Victoria summarizes these ideas for Bob. The debt-free methodology first estimates Acme‟s
business enterprise value. If Bob were to sell Acme in an asset sale, he would be interested in this
value. But if the transaction were structured as a sale of all of Acme‟s stock, Bob would want to know
the value of the shares. In this case, the value of Acme‟s debt capital would be subtracted from its
business enterprise value, which would produce an estimate of the value of Acme‟s shares. Victoria
tells Bob that although the debt-free methodology is more complex than the direct equity
methodology, it is needed to value Acme‟s shares since the firm does not have the optimal capital
structure of debt and equity.
Adjustments to Earnings for Valuation Purposes