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?

Answer 1

Advantages of Cash flow valuation models:

1. It doesn't depend on any external base for providing meaningful analysis.
2. It takes into account all information relevant for ascertaining cashflows.
3. Useful tool for determining the intrinsic value of the proposed investment.
4. Can be easily performed in many finance application tools like spreadsheets, etc
5. Efficient tool for analysing mergers and acquisitions.

Limitations may be:

1. Simple errors in basic data can result in wrong computations and conclusions.
2. Terminal value is difficult to estimate.
3. Determining the discount factor is another challenge.
4. Based on too many assumptions.
5. Difficult to understand and involves complex computations.

2. Generally Cost of Capital is average weights of cost of equity and cost of debt. Cost of debt is generally lesser than the Cost of equity. Thus when debts increases, due to the cheaper cost, overall Weighted Cost of Capital will come down. But this won't continue for long. As equity holders will demand more returns. As a result the reduced cost of debt is offset by increased cost of equity. Hence overall Cost of Capital remains same.