Question

1. “Valuation is said to be part art and part science.” Explain what this means with respect specifically to the discounted cash flow analysis. [ Answer the question in no more than 5 total sentences]

2. Explain why preferred stock is like debt. Explain why preferred stock is like equity. Why might a firm issue preferred stock instead of common stock or debt. [ Answer the question in no more than 5 total sentences]

Answer 1

1. Valuation of a company is especially when we perform discounted cash flow analysis is a mixture of art and science. The easy part is the maths involved (which is science) where in we use the discount rates and calculate the present values and arrive at the estimated valuation. However, the more important thing is the asumptions we make to arrive at the projected future cash flows, the cost of equity (cost of debt is still straight forward), scenario analysis about the macro economic environment - these assumptions though based upon analysis are still subjective and this is the part which is like art. The final resultant valuations can be very different if the future projections are incorrect, hence given it is a subjective skill we can call the valuation process a combination of art and science.

2. Preferred stock is essentially a hybrid security which has features of both debt as well as equity. It has higher claim compared to common equity class on payment and the dividends on preferred stock should be paid out before paying out to common equity class. But they do not have any voting rights and like debt it payd a fixed dividend, but if the company fails to pay a preferred stock dividend, the company will not be put into default like the case is for default in bonds. Preferred stock can be way to raise funding without diluting the voting rights of the common equity class and at the same time without impacting the debt equity ratio and/ot other debt covenants stipulated by the creditors.