THEORIES

Question 1: Conditions where net cash flows method is preferable:

The net cash flows method is preferable when a company does not pay dividends; the company pay
dividends, but the amount paid significantly differs from its capacity to pay dividends; net cash flow and
profits of an entity is aligned w/in a reasonable forecast period; and when the investor has a control
perspective. It is preferable for an entity that isn’t involved in financing activities (e.g. payment of
dividends) to use the net cash flow method since it only focuses on operating and investing activities. In
the second scenario, the entity pays dividends to its shareholders in small amounts and immaterially
affects its earnings, thus the net cash flow method is still applicable. Another condition where the net
cash flow method is preferable is when the net cash flow and profit of an entity is aligned because it
denotes that the revenue of the said entity is easily convertible into cash (liquidity). And lastly, if the
investor has significant control over the payment of dividends, then the use of net cash flow method is
appropriate since the dividends can be adjusted based on the decision of such an investor.

Question 2: Differentiate 2 levels of Net Cash Flow:

There are two levels of net cash flow, they are: Net Cash Flow to the Firm and Net Cash Flow to Equity.
Net cash flow to the firm only pertains to cash flow generated from operating and investing activities,
while net cash flow to equity includes all cash flow produced by operating, investing and financing
activities. Addition to this, net cash flow to the firm represents the amount available for outside
creditors, common and preferred stockholders. On the other hand, the net cash flow to equity
represents the amount available to common stockholders after deducting the outstanding liabilities
from outside creditors and preferred stockholders.

Question 3: Factors why net cash flows and its sources helpful to analysts:

There are four factors why net cash flows and its sources are helpful to analysts, namely: source of
financing for needed investments; reliance on debt financing; and quality of earnings. It is vital for the
firm to fund its investment through cash from operations because the heavy reliance from lenders or
shareholders denotes that the cash of an entity from its operations doesn’t have the capacity to support
the firm’s long-term stability. Debt financing is an inevitable and excellent activity when it comes to an
expanding venture, however, when the firm’s cash from operation is not sufficient to repay existing debt
obligations and it rely from another borrowing to refinance the prior ones, then it can become a
problem. There is a low quality of earnings when there is a big difference between cash flows and
income because it may indicate that the earnings don’t have the ability to be converted into cash easily.

Question 4: Disadvantage of Net Cash Flow

The disadvantage of using Net Cash Flow is that it only considers the amount net of the applicable taxes
to be paid because the basis of its computation is already the earnings after excluding the financing
costs, taxes and other non-cash charges. Moreover, the assets of the entity that cannot be easily
converted into cash can be disregarded as this method only concerns cash.

Question 5: Difference of Net Income, Statement of Cash Flows, EBITDA

The difference between the computation using net income, statement of cash flows, and EBITDA are
their starting points. In computing using the net income the basis is the amount after the deduction of
all expenses/charges while in EBITDA the basis is the earnings only before taxes, depreciation and
amortization. In computing using the statement of cash flow, the starting point will be the amount of
cash flows from operating activities. With all of these being said, the differences of starting point of
these 3 methods of computation will result to different number of adjustments.

Question 6: Two opposing theories in income-based valuation

There are two opposing theories in income-based valuation, they are: Dividend Irrelevance Theory and
Bird-in-the Hand Theory. Dividend Irrelevance theory believes that stock prices are not affected by
dividends or the returns on the stock but more on the ability and sustainability of the asset or company.
On the other hand, bird-in-the hand theory believes that dividends or capital gains have an impact on
the price of the stock.

Question 7: Factors affecting the Proper Value of the Asset

There are four factors affecting the proper value of the asset namely: earning accretion; earning
dilution; equity control premium; and precedent transactions. Earning accretion is an additional value
input in the calculation for the increase in value of the firm while earning dilution reduces the value of
the entity when there are future circumstances that will affect the firm negatively. Equity control
premium is the amount added to the value of the firm to gain control. And lastly, precedent transactions
are the previous deals or experiences that can be like the investment being evaluated.

Question 8: Cost of capital can be computed through:

There are two ways to compute cost of capital, they are: weighted average cost of capital and capital
asset pricing model. The weighted average cost of capital can be used to determine the appropriate cost
of capital through weighing the portion of the asset funded through equity and debt. On the other hand,
capital asset pricing model can be used to determine a theoretically appropriate required rate of return
of an asset.

Question 9: Approach in determination of the value of the cash flows:

There are three approaches in determining the value of the cash flow, namely: economic value added;
capitalization of earnings method; and discounted cash flows method. Economic value added is a
convenient metric in evaluating investment as it rapidly measures the firm’s ability to support its cost of
capital using its profits. Capitalization of earnings method determined the value of an asset using the
anticipated earnings of the company divided by the capitalization rate. The discounted cash flows
method is the most popular method in determining corporate value as it determines the present value
of the projected net cash flow of the firm.

Question 10: Limitations of Capitalization of Earnings Method

Capitalization of Earnings method may not fully account for the future earnings or cash flows thereby
resulting to over or undervaluation, inability to incorporate contingencies, and the assumptions used to
determine the cash flows may not hold true since the projections are based on a limited time horizon.
These limitation of Capitalization of earnings method incurs as it only associate with the anticipated
earning or income earnings based on the historical earnings and anticipated earnings of the entity.