A generalized model for the value of any asset is the present value of the expec

Question

A generalized model for the value of any asset is the present value of the expected cash flows:

Value equals the summation from t equals 1 to N of CF sub t over open parenthesis 1 plus k close parenthesis to the t power

Where:

N ; equals ; life of the asset ; CF sub t ; equals ; cash flow in Period t ; k ; equals ; appropriate discount rate ;

Both stock and bond valuation models use a discounted cash flow approach, which includes the estimation of three factors (N, CFt, k).

Explain why each of these three factors is generally more difficult to estimate for common stocks than for traditional corporate bonds.

Explanation / Answer

Even though both the Common Stocks and Traditional Corporate Bonds use the same Three Factors the estimation of Common Stocks is always difficult compared to the Traditional bonds because:

N=Life of Asset is never fixed in any of the common stocks i.e. life of common stock is Perpetual which doenot end as the common stock holders are the owners of the entity and an entity is said to be perpetual i.e company is expected to be run for a for time.Even going concern concept indicates the same. But whereas the Bonds are the debt of an entity which has a fixed repayment terms and schedule.

CF-Cash Flows.Cash flows for Bonds may be fixed according to the terms of repayment and contract interest rate but cash floes in case of common stock is dividend which is never fixed and nor can be accurately estimated even after a long analysis one can not be sure of the rate of dividend or yield a particular common stock might give.

K-Ofcourse K is the major role player and the toughest part of extimation process. As the cost for debt can be fixed cost of common capital can never be fixed as the expectations of the investors change the profits change the investment strategies change and the overall economy changes also effect the cost (k i.e. Discount rate) So many factors which are not even in a bit of our control effect the k in case of common stock the number of factors influencing are even soo dynamic that we can never reach to an estimate which is perfect.

So overall to value an asset we make so many assumptions so the value is just an estimate to lay down a path.

It may not be perfect but accuracy can be attained on performing a detailed research on all the factors influencing the above three estimates in case of common stocks.

Hope you are satisfied.

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