Financial and Accounting Calculations - Essay Example

The primary difference between the two cash flows is that; the FCFF is available to the debt and equity holders of the firm whereas the FCFE is restricted to the equity shareholders of the firm.

The FCFE approach pertains to the common stockholders. Unlike the FCFF, which incorporates the EBITDA, the ownership perspective holds that neither does EBITDA account for different capital frameworks nor does it account for cash flow from bondholders. Common stockholders argue that EBITDA fails to allow for adjustments from reinvesting cash flows to improve the value of the company in the long term.

Many financial analysts utilize historical data to establish the ex-ante risk premium. Such an approach to predict the future performance of stocks and bonds raises some valid concerns within the commercial markets. Besides being difficult to establish the data series and period to use, some analysts argue that historical data is ambiguous and is not a legitimate method to forecast future returns. In addition, historical data sets are viewed as being independent of each other and are equally distributed over the period. However, returns on investments are negatively correlated with each other.

Standard Error: If the returns in the U.S. data being used are correlated, the standard error would increase.

Statistical Stationarity: The previous financial performance may not indicate the future financial performance in a financial market. For example, in the U.S., changes in the stock market in the 20th century indicate a stationary return series.

The ability of shareholders’ investments to generate profits results in the Return on Equity (ROE).

When the Return on Capital (ROC) reduces, the Return on Equity (ROE) significantly reduces, ceteris paribus. Shareholder equity forms part of investment capital. If the capital invested fails to realize the forecasted capital gains, the net income attributable to shareholder equity significantly reduces.

A decrease in leverage increases the return on equity. Reduced long-term debt stimulates capital investments based on shareholders’ equity; that is, low long-term debt induces investments based on shareholders’ equity. Capital investments based on shareholders’ equity would increase the return on equity with all other factors remaining constant.

A decrease in the debt interest expense means that more long-term debt will be available from lenders. Excess funds from long-term debts would stimulate investments based on leverage, with all other factors remaining constant. This would reduce capital investments based on shareholders’ equity; hence reducing the return on equity.

A low-profit margin would result in a decrease in the return on equity. A low-profit margin would result in a lower net income after deducting the preferred stockholders. The resulting net income divided by the common stockholders’ equity would reduce, ceteris paribus.

Operating income tends to be volatile due to the rapid changes in the flow of business and differing accounting transactions. As a result, operating income ought to be smoothed rather than being normalized. Smoothing should be conducted in a way to only allow the accounting analysis of an event, rather than the event itself. The smoothing procedure acknowledges that the Generally Accepted Accounting Principles (GAAP) allow realistic independence in reporting procedures. The smoothing hypothesis is flexible as it ‘manipulates’ earnings regularly to cater to the changes in the flow of business and accounting transactions.