Why do investors typically accept a lower risk-adjusted rate of return on debt capital than equity capital? Suppose a stable, financially healthy, profitable, tax-paying firm that has been financed with all equity now decides to add a reasonable amount of debt to its capital structure. What effect will the change in capital structure likely have on the firm’s weighted-average cost of capital?
12.6 Valuation When Free Cash Flows Are Negative.
Suppose you are valuing a healthy, growing, profitable firm and you project that the firm will generate negative free cash flows for equity shareholders in each of the next five years. Can you use a free-cash- flows-based valuation approach when cash flows are negative? If so, explain how a free-cash-flows approach can produce positive valuations of firms when they are expected to generate negative free cash flows over the next five years.
Sample Solution
