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You are required to explain the following questions to your Board of Directors (BOD):
- Why the Discounted Cash Flow (DCF) method are better than the other methods of financial analysis such as discounted dividend model (DDM) and ratio analysis. How to apply the DCF to find the corporate value of the acquired company?
- Why is analysis of a company's capital structure important? What are the effect of financial leverage on capital structure and equity value of a company.
Requirement: same as first assignment which you have done- 2 pages
1. DCF Valuation
a. Significance of DCF over DDM and Ratio Analysis
Discounted cash flow (DCF) method is a traditional business valuation technique which is used to estimate the risk and uncertainty involved in a proposed project (Maroyi & Poll 2012). The two widely used measures are Net Present Value (NPV) and Internal Rate of Return (IRR). NPV is based on applying discounting on the expected future cash flows of a project. If a proposed project is selected, as per NPV, the present value of cash inflows i.e., benefits for the company has to be more than the cash outflows i.e., expenditure. The major advantage of NPV is the use of all the cash flows of a proposed project in the calculation whereas the disadvantage is the estimation of discount rate prior to the computation. For projects with different economic life or investment amount, NPV offers different suggestions which are not comparable. The IRR uses a percentage rate of return as the deciding factor. It is calculated to determine the discount rate for which the NPV is zero. To decide on the project selection, IRR is compared with the cost of capital. IRR is easy to interpret and easy for application as discount rate is not estimated. Disadvantage arises with the use of a combination of positive and negative cash flows which result in multiple and the unrealistic assumption that cash flows are reinvested in the IRR. Thus, the concept behind DCF is based on the assumption that the value of share is equivalent to the sum of future cash flows to equity discounted based on risk and time.
Discounted Dividend Model (DDM) is based on the assumption that the value of share is equivalent to the sum of future dividends paid to shareholders which are discounted for risk and time (Foerster & Sapp 2005). In DDM, the predictability and sustainability of a dividend is essential as drastic changes in dividend growth or payout ratios would impact the accuracy of the DDM. This model does not consider the reinvestment of dividends which is important to estimate the cumulative returns. Taxation of dividends is a major issue as taxes are incurred annually when compared to capital appreciation which is taxed on the realization of capital gain. It is observed that both DCF and DDM are absolute valuation models to evaluate the value of a company. However, DDM is applicable to companies' offering dividends on stock whereas DCF is applicable to non-dividend paying firms. Thus, DCF is a better model than DDM despite the need for vast amount of data for valuation.
In the case of ratio analysis, price-to-earnings ratio (P/E), price-to-sales ratio (P/S), and enterprise value-to-earnings before interest, tax, depreciation and amortization (EV/EBITDA) are used which are compared with peers to compute a company's equity value (Agar 2005). These ratios are volatile and subject to changes occurring in the external environment of a company, its operating industry and stock market. The ratios are calculated based on the book value. The major advantages are ease of application, limited number of assumptions, reflect the market conditions and consider business cycles. However, the subjectivity related to the choice of ratios and identifying comparable peers are a major issue. Though forecasting earnings of cyclical companies is difficult in DCF, it is better than ratio analysis due to the accuracy of inputs required in valuation.