Question

16. Which of the following is true regarding the sensitivity of the Free Cash Flow valuation model to errors? a. The future terminal (continuation) cash flow is extremely sensitive to forecasting and growth rate errors. b. All else being equal, a terminal (continuation) value computed 10 years from today with a 3% overstatement in the growth rate will bias the intrinsic valuation more than if the terminal (continuation) value computation were made in 6 years with a 3% overstatement in growth. c. Financial statements after the year 2002 provide less accurate information regarding the market value of debt than financial statements prepared in the late 1980’s. d. Cash flow based statements provide more forward looking information than do accrual based statements and valuation methods. e. Free Cash Flow valuations are riddled with errors and do a poorer job of explaining and forecasting stock prices that the Discounted Dividends model.

Answer 1

16.

Option A is correct. The terminal value accounts for much of the value generated from a DCF analysis. It depends heavily on the growth parameter. Hence it is very sensitive to changes in growth rate.

Option B is incorrect because the longer we forecast the lesser the value is contained in the terminal value as a percentage of the total calculated value.

Option C is incorrect because the financial markets are more accurate in calculating the debt in 2002 as compared to 1980's as the markets have become more efficient and transparent.

Option D is incorrect because it tells the cash balance in the present rather than the future.

Option E is incorrect. While both the models use their assumptions, the Dividend Discount model is more error prone as it totally depends on the predicted dividends and their growth and dividends are assumed to be the only source of cash flow. It ignores the operational cash flows of the firm. Another assumption is that this model can be applied only to mature companies which itself makes it inapplicable for most of the companies.