Chapter 9 questions
Question 1
The discounted cash flow valuation approach determines the value of a firm by discounting the expected cash flows from the firm (Voss & Larrabee, 2012). The value of any firm or asset should be equal to the present value of the cash flows expected from the firm or asset. Since the firm’s value is determined today, the least an investor would be willing to pay is the present value of the sum cash flows expected from the enterprise (Voss & Larrabee, 2012). Discounting is based on the time value if money. A firm will generate a stream of cash flows over a long period. However, the payment is made now hence discounting helps in determining the present value equivalent of such streams. The cost of the firm, which is the amount paid by the acquiring firm/investor, should be equal to the present value of the expected benefits.
Inputs required for DCF analysis
Discount rate
This is the cost of equity or the cost of capital. The discount rate used depends on the risk and the type of cash flows. Cash flows to equity are discounted using the cost of equity while those to the firm are discounted using the cost of capital.
Cash flows
DCF analysis requires the estimation of cash flows. Cash flows can either be to the firm or equity.
Growth
It is also important to determine the expected growth in earnings. This implies the growth in equity earnings as well as the growth in firm earnings (operating income). The growth rate in earnings helps in estimating future earnings and the value of the firm or equity.
Question 2
The intuition behind the capital asset pricing model is that all investors are risk-averse and would require a higher return than the risk-free rate to accept any risk. Therefore, the required return is the risk-free return plus the risk premium (Cornwall, Vang, & Hartman, 2013). The risk premium is based on the beta of the asset or firm and varies from one asset to another. This implies that investors require a higher for a higher risk. The model assumes a linear relationship between returns and beta.
The model is not reasonable for an entrepreneur or investor. The assumption that return and beta are linearly related is unreasonable. Besides, there are several factors affecting risk and return and not only beta as the model assumes.
Question 3
The cost of capital is usually lower than the cost of equity since the cost of debt is lower than the cost of equity (Cornwall, Vang, & Hartman, 2013). Therefore, it is necessary to match cash flows and discount rates to avoid misleading or biased results. If cash flow is to equity, then the cost of equity should be the discount factor. If the cost of capital is used, then the value of equity will be biased upwards (overstated). When the cash flows are to the firm, the cost of capital should be the discount factor. Using the cost of equity to discount cash flows to the firm will understate the value of the firm.
Question 4
The main difference between the two is on the risk adjustment. Under the RADR approach, it is the discount rate that is adjusted to obtain a risk-adjusted discount rate (Smith, Smith, & Bliss, 2011). The risk-adjusted rate is then used to discount the expected cash flows. On the other hand, the CEQ does not adjust the discount but adjusts the expected cash flows (Smith, Smith, & Bliss, 2011). It converts uncertain cash flows into certain cash flows based on a certainty equivalent.
The CEQ is preferable to RADR in the case of new ventures since there is no comparable information about new ventures. The risk-adjusted rate is based on data obtained from similar firms (Smith, Smith, & Bliss, 2011). For new ventures, that data is not available hence determining the certainty equivalents is the best approach.
References
Cornwall, J., Vang, D., & Hartman, J. (2013). Entrepreneurial financial management.
Armonk, N.Y.: M.E. Sharpe.
Smith, J., Smith, R., & Bliss, R. (2011). Entrepreneurial finance. Stanford, Calif.: Stanford
Economics and Finance.
Voss, J. & Larrabee, D. (2012). Valuation Techniques: Discounted Cash Flow, Earnings
Quality, Measures of Value Added, and Real Options (CFA Institute Investment Perspectives Series). John Wiley & Sons.
