Question

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?

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Answer 1

ADVANTAGES OF CASHFLOW BASED VALUATIONS

• Cash flow based valuation truly captures the underlying fundamental drivers of a business
• reliable measure that eliminate the subjective accounting policies and window dressing involved in reported earnings.
• allows investors to incorporate key changes in the business strategy in the valuation model, which otherwise will go unreflected in other valuation models
• While other methods like relative valuation are fairly easier to calculate, their reliability becomes questionable when the entire sector or market is over-valued or under-valued.

DISADVANTAGES OF CASHFLOW BASED VALIUATIONS

• sensitive to assumptions related to perpetual growth rate and discount rate.
• It works best only when there is a high degree of confidence about future cash flows
• One major criticism of this is that the terminal value comprises far too much of the total value

A firm's WACC increases as the beta and rate of return on equity increase because an increase in WACC denotes a decrease in valuation and an increase in risk

Assuming that the cost of debt is not equal to the cost of equity capital, the WACC is altered by a change in capital structure. The cost of equity is typically higher than the cost of debt, so increasing equity financing usually increases WACC.

Leverage is the ratio of debt to equity. So, as the proportion of debt to equity increases, the weighted average cost of capital declines. This is due to debt being cheaper than equity, since debt is tax-advantaged.