This case is about ACCOUNTING

PUBLICATION DATE: March 29, 2001 PRODUCT #: 201110-PDF-ENG

Valuing the Option Component of Debt and Its Relevance to DCF-Based Valuation Methods Case Solutions

The flows-to- equity or equity cash flows valuation process is a discounted cash flow approach used to estimate the equity part of the capital structure. It is closely linked to the venture capital/buy out valuation approach, which estimates the IRR of the stream of cash flows accruing to equity holders.

Both of these procedures are likely to lead to an approximation of equity value that’s too low when the firm’s debt is uncertain (or, equivalently, an IRR that’s too high, depending on the approach used to estimate terminal value). This case explains a way of estimating the size of this bias, drawing insight from option-pricing.

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