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In the second approach, the Free Cash Flow to the Firm (FCFF) model, we compute the Weighted average of the cost of equity and debt to get a market value of the cost of capital - which in turn constitutes our discount rate. So, which approach is better? FCFE has fewer inputs and can be more easily computed than FCFF, but requires a higher dose of precision. When talking about precision in means using appropriate values (market vs book) and making sure not to double count items.

The FCFF model allows for more maneuvering and changing of more assumptions. It is important to note, that if done right, both valuations will give a similar estimate. That is one way to see if it is appropriate to use the simpler method, for a certain firm. If these numbers do not converge, then we need to consider the structure and underlying assumptions of the firm and go with the more complex model or an entirely different approach - like a high growth firm valuation.

In our first segment, we will look at where leverage (debt) appears in a DCF valuation. For that, we look at a financial balance sheet and see that debt is located on the liability side of the statement. **Let's look at table 1, and go through each statement separately.**

Assets

Liabilities

The expected value of investments already made

Assets in place

Debt

Borrowed money

Expected change in the value of future investments

Growth assets

Equity

Owner’s funds

As we can see, there are 4 main items on the sheet. Two of those are included in the computation of the cost of capital for a firm’s valuation.

Those are:

The cost of debt is the interest rate that long term lenders demand today. What premium should I demand given the default risk and the length of the loan

Drivers:

The possible tax benefits from interest expenses - tax benefits come from the marginal rate. The cost of equity (Hurdle rate) is the equity return investors demand. How much must the return be given the risk of my investment?

Drivers:

Both of these estimates are included in the computation WACC (Weighted Average Cost of Capital), which is one of the fundamental parts of a DCF valuation. The WACC is the weighted average of the Cost of Capital (weighted by its drivers).

Drivers:

- Cost of equity

- Cost of debt

It is ultimately defined by the consolidated risk of the firm.

After that, we need to add the weights into the equation. They need to be market value weights - and not book value. The way to think about the market value weights is that they reflect the cost of acquiring the entire business today.

This shows us where debt (leverage) plays a role in the DCF statement. Now we need to look at the type of role it plays, and its extent.

Leverage mainly plays a role in the risk of a firm, and therefore is accounted for at the discounted rate. The riskier the asset - the greater the discount rate. This is the simple part.

The more nuanced part is coming up with a good estimate for risk.

We will see that risk is present in multiple ways in a DCF analysis, and one major point is making sure that we separate the risk rates in their appropriate categories and not double count them.

Types of risk included in the cost of capital:

The amount of leverage drives the cost of capital and is influenced by taxes, default risk and agency problems. There are three numbers that need to be estimated in order to get the cost of capital:

Sovereign credit default swaps. It offers a market-based estimate of sovereign risk. Country risk premiums. A scaling factor added on top of default spreads, that reflects the risk of equities vs government bonds.

You need to start by estimating the risk-free rate, which may be difficult in emerging markets since even the government bond rates have default risk embedded in them. A way to control this is to take the 10 years government bond rate and net out the default spread for that country. This shows us what the risk-free rate would be if there was no default risk.

(LC = local currency)

Of all the drivers, we see that leverage risk is highly intertwined with a firm’s beta estimate - which is part of the business risk. This type of risk can be alleviated by adopting a diversification approach to an investment portfolio. And with this assumption in mind, we need to focus on the magnitude of the leverage risk, which shows us how much can a firm cope with financial stress and to which extent does it have default risk. Both of these factors are emphasized when determining the discount rate in a DCF.

In general, leverage negatively influences the final value of the stock. A quick screen of the debt to equity ratio can indicate if we should take the simpler approach or incorporate leverage into our DCF valuation.

The relationship between the effect of leverage on the final value is not linear since higher debt to equity ratios increase the strain on the firm and result in a higher discount rate in a DCF.

For the firm, a good mix of debt to equity is dependent on the stability of revenues, the tax incentives of the country(es) it operates in, hurdle rates and the default risk.

It is a disciplinary tool since management will have to put more focus on profitable projects that are above the hurdle rate.

The country of incorporation may incentivize leverage by including (more) tax benefits. More debt makes the firm a bad target for a hostile takeover.

- Bankruptcy risk increases, especially in volatile economies.
- The more levered a firm, the higher the cost of capital becomes.
- The interests of investors and lenders will clash.

In closing, the difference between levered and Unlevered DCF valuation is impacted by the amount of debt that a firm holds. We should first screen for the debt to equity ratio, before picking the DCF approach in valuation, if you are a developer you can use a Free financial API where you can directly access this ratio via any programming language to screen for this ratio and see in detail the difference between levered and Unlevered DCF and then the impact on companies valuation.