Distortion in corporate valuation: implications of capital structure changes

Abstract

Purpose The traditional discounted cash flows (DCF) valuation procedure used by financial analysts assumes that firms maintain a policy of fixed debt. However, empirical evidence suggests that many firms rebalance their debt. This paper seeks to explore the implication of this discrepancy for valuation of firms that undergo a capital structure change. Design/methodology/approach The approach taken is both theoretical and empirical. Findings The authors show how the valuation process should be modified for firms that are expected to rebalance their debt and demonstrate the distortion in value that results if the traditional DCF valuation procedure is used instead. Furthermore, they illustrate the significance of their results using a sample of the largest largest leveraged buyouts of the current decade. Originality/value To the authors' knowledge, this is the first investigation into this issue.