Reference no: EM132550753

Part 1.

What are some advantages of valuating a stock based on discounted cash flows? With the availability of cash flow valuations, why might investors display trading biases and what might be some potential consequences? Why might corporations use call features and restrictive covenants on bond issues?

Part 2.

"DCF method is very regularly related to value firms and stocks. The advantage of applying this methodology is that it correlates to almost every parameter of business, which is vital for driving its intrinsic value such as WACC, reinvestment, growth. Moreover, its calculations are based on free cash flows from the firm, which is available for the investors. The strong foundation of the DCF method is what enables its use in other applications and valuation methodologies.Despite the above-listed advantage, this method is exposed to some disadvantages which may set the bias in valuation. The valuation exercise is based on essential levers such as WACC and growth rate. These numbers are quite challenging to estimate instantly and may involve the perception of the traders/analysts during estimation. Small delta change in certain variables results in a significant change within the value of the firm. So, proper caution has to be taken during the estimation of the variables that directions be used.Corporations may prefer to incorporate the call feature in their bond issue, which provides the right (but not obligation) to separate the bond on a specific date before maturity. This feature helps them to get added flexibility in deciding if to retire debt based on the operational cash flows and free cash flows coming from the business. However, it has been observed that the callable bonds frequently trade at a lower price than equivalent non-callable bonds. Restrictive covenants are additionally handled to restrain the actions of corporations in the bond issue. This is mainly gain the confidence of investors to the bond so that they may feel that their interests are protected. In the absence of covenants, the borrower may increase the firm's risk to an alarming level without compensating additional interest to the bondholders."