Paul Ulring, Chief Executive Officer of Arlington Machinery, has asked Sara Trafer about the benefits of using a variety of valuation models for evaluating capital projects. In response to Ulrings questions, Trafer makes the following statements: Statement 1: The economic profit, residual income, and claims valuation methods of valuation should all result in the same valuation for an asset or project, despite the use of different discounts rates in the calculations. Statement 2: The claims valuation and economic profit valuation models both include cash flows that will flow to debt holders, and the cost of debt is a factor in both calculations. Are the statements as made by Trafer correct? Statement 1 Statement 2 A) Correct Correct B) Correct Incorrect C) Incorrect Correct D) Incorrect Incorrect
B?
well the second statement should be incorrect, given that WACC is used for the calculations and not cost of debt (eliminates A and C) not sure about #1
Cost of debt is embedded in WACC
Your answer: B was incorrect. The correct answer was A) Correct Correct
A.
D ?
Can u post the detailed explanation … or alternatively quote the Question ID
What the is claims valuation?
“Claims valuation” states that the value of a firm is the sum of cash flows attributable to debt holders and cash flows attributable to equity investors
Kumar here you go - Trafers first statement is correct. In theory, all three of the different valuation approaches should lead to the same result, despite the economic profit method using the WACC, the residual income method using the cost of equity, and the claims valuation approach separately using the cost of debt and cost of equity as discount rates. Trafers second statement is also correct. The claims valuation approach looks at cash flows to equity holders and debt holders separately, while the economic profit method looks at cash flows from the perspective of all suppliers of capital, so debt holders concerns are included in both methods. Also, the discount rate used with the economic profit method is the WACC, while the claims valuation approach considers the cost of equity and the cost of debt separately, so the cost of debt is a factor in both calculations. Black Swan - Claim Valuation is basically separating the valuation of the cash available for bondholder and cash available for shareholders and then adding them together to determinine company value. To value cash for bondholders we use Cost of Debt and to value cash for shareholders we use Cost of Equity as the Discount Rate. Makes Sense??
Gotcha.