Question

Assignment

Discuss the strength and weaknesses of cash-flow based valuation models. How do variations in the required cost of capital for debt and equity shareholders affect valuation? Present your analysis and discussion in a one to two page.

Answer 1

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Discuss the strength and weaknesses of cash-flow based valuation models. How do variations in the required cost of capital for debt and equity shareholders affect valuation? Present your analysis and discussion in a one to two page.

Strengths

1. Discounted cash flow methods are better than other methods since they consider the earnings of a project over its entire economic life, and also the time value of money flows

2. Their Conclusions are not biased or influenced by decisions such as depreciation methods or capitalization or expensing decisions. They are more objective-oriented.

3. As they consider present value factors the method gives more weight to units of money, which are nearer than those, which are distant.

4. The Discounted cash flow method allows a ready comparison to be made between projects having different lives and different timings of each flow by facilitating comparison at the same point of time.

5. By comparing the rates of return of projects with the cost of capital ratios, decisions can be taken quickly.

Weakness

1. The methods are considered difficult to understand and operate. However, compared to other complex statistical methods the DCF methods seemed to be easier in some cases.

2.  It is against the assumption of a fixed investment rate throughout the life of the project. This assumption arises mainly because of the use of compound interest principle as the basis of these methods.

3. They fail to take of risks and uncertainties into account at the time of calculations.

4. The IRR and NPV methods give rise to conflicting issues while decisions are taken.

How do variations in the required cost of capital for debt and equity shareholders affect valuation?

The Cost of Capital is used to calculate the value of a firm (Debt and Equity). It is used in the following formula at the time of calculation of DCF

1. Cash Flow (CF)

It represents the free cash payments an investor receives in a given period for owning given security (bonds, shares, etc.)

When building a financial model of a company, the CF is typically what’s known as un levered free cash flow. When valuing a bond, the CF would be interest and or principal payments

2. Discount Rate (r)

The discount rate is typically a firm’s Weighted Average Cost of Capital(WACC). Investors use WACC because it represents the required rate of return that investors expect from investing in the company.

For a bond, the discount rate would be equal to the interest rate on the security.

3. Period Number (n)

Each cash flow is associated with a time period. Common time periods are years, quarters or months. The time periods may be equal, or they may be different. If they’re different, they’re expressed as a decimal.

The WACC or the cost of capital which is used in the formula defines the Net positive effect on the company. It affects valuation. Many investors weigh different risk factors and consider the proper required rate of return and the valuation changes accordingly.

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