Test ID: 7441130
Free Cash Flow Valuation
Question #1 of 145
Question ID: 463221ᅚ A) ᅞ B) ᅞ C)
An analyst has prepared the following scenarios for Schneider, Inc.: Scenario 1 Assumptions:
Tax rate is 40%.
Weighted average cost of capital (WACC) = 12%. Constant growth rate in free cash flow = 3%. Last year, free cash flow to the firm (FCFF) = $30. Target debt ratio = 10%.
Scenario 2 Assumptions: Tax rate is 40%.
Expenses before interest and taxes (EBIT), capital expenditures, and depreciation will grow at 15% for the next three years.
After three years, the growth in EBIT will be 2%, and capital expenditure and depreciation will offset each other. WACC during high growth stage = 20%.
WACC during stable growth stage = 12%. Target debt ratio = 10%.
Scenario
2
FCFF
Y
ear
0
(last
year)
Y
ear
1
Y
ear
2
Y
ear
3
Y
ear
4
EBIT $15.00 $17.25 $19.84 $22.81 $23.27 Capital Expenditures 6.00 6.90 7.94 9.13
Depreciation 4.00 4.60 5.29 6.08
Changein Working Capital 2.00 2.10 2.20 2.40 2.40
FCFF 5.95 7.06 8.25 11.56
Assuming that Schneider, Inc., slightly increases its financial leverage, what should happen to its firm value? The firm value should:
increase due to the additional value of interest tax shields.
not change becausefinancialleveragehasnorelationship withfirm value. decline duetotheincreaseinrisk.
Explanation
Questions #2-7 of 145
Question #2 of 145
Question ID: 463279ᅞ A) ᅞ B) ᅚ C)
Question #3 of 145
Question ID: 463280ᅞ A) ᅚ B) ᅞ C)
Harrisburg TireCompany (HTC)forecaststhefollowing for 2013: Earnings (netincome) = $600M.
Dividends = $120M. Interestexpense = $400M. Tax rate = 40.0%. Depreciation = $500M. Capitalspending = $800M.
Totalassets = $10B (book valueand market value). Debt = $4B (book valueand market value). Equity = $6B (book valueand market value). Target debttoassetratio = 0.40.
Sharesoutstanding = 2.0 billion
Thefirm'sworking capitalneedsarenegligible, and HTC plansto continuetooperatewiththe current capitalstructure.Thetireindustry demand ishighly dependenton demand fornewautomobiles. Individual companiesintheindustry don'thave muchinfluenceonthe designofautomobilesand have very littleability toaffecttheir businessenvironment. The demand fornewautomobilesishighly cyclical but demand forecasterrorstend to below.
Thefirm'searnings growthrateismostaccuratelyestimated as:
6.4%.
4.8%.
8.0%.
Explanation
Thefirm'sestimated earnings growthrateisthe productofitsretentionratioand ROE: g = RR × (ROE) = [(600 − 120) / 600] × (600 / 6000) = 0.08 (LOS 35.o)
The 2013forecasted free cashflowtoequity is:
$300M.
$420M.
$340M.
Explanation
Since working capital needs are negligible, the free cashflow to equity is: FCFE = Net income − [1 − DR)] × [FCInv − Depreciation] − [(1 − DR) × WCInv]
FCFE = 600M − [1 − 0.4] × (800M − 500M) = 420M
where:
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Question #10 of 145
QuestionID:463232ᅞ A)
less than the market value of the firm by $3.3 billion.
less than the market value of the firm by $7.5 billion. greater than the market value of the firm by $0.7 billion.
Explanation
FCFF = FCFE + Interest expense × (1- t)-net borrowing = $400 million + $400 million × (1-0.40)- ($40 million- $60 million)
= $660 million.
Value of the firm = [$660 million × (1.05)]/(0.115-0.05) = $10.662 billion. Thisis a difference of $0.662 billion compared to the $10.0 billion current market value. (LOS 36.j,m)
Afirm currently hassales pershareof $10.00, and expectssalesto grow by 25% next year. Thenet profit marginisexpected to be15%. Fixed capitalinvestmentnetof depreciationis projected to be 65% ofthesalesincrease, and working capitalrequirementsare15% ofthe projected salesincrease. Debtwillfinance45% oftheinvestmentsinnet capitaland working capital. The company hasan11% required rateofreturnonequity. Whatisthefirm'sexpected free cashflowtoequity (FCFE) persharenext yearundertheseassumptions?
$0.38.
$1.88.
$0.77.
Explanation
FCFE = net profit- NetFCInv - WCInv + DebtFin = $1.88 - $1.63-0.38 + 0.90 = 0.77
Inusing FCFE models, the assumptionof growthshould be:
independent from the assumptions of other variables.
only consistent with the assumptionsof capital spending and depreciation. consistent with assumptionsofother variables.
Explanation
The assumptionof growthshould be consistent with assumptions about other variables. Net capital expenditures (capital expenditures minus depreciation) and beta (risk)used to calculate required rate of returnshould be consistent with assumed growth rate.
Whichof the following statements about the three-stage FCFE model ismost accurate?
Question #11 of 145
QuestionID:463179ᅚ A) ᅞ B) ᅞ C)
Question #1
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QuestionID:463180ᅞ A)
Long-term debt $4,528 $5,039
Commonstock $729 $735
Retained earnings $15,725 $15,093
Total liabilities and owner's
equity $28,337$28,406
Figure 2: Example Cash Flow From Operations
20X2 20X1
Net income $1,783 $2,195
Depreciation $376 $267
WCInv ($178) $357
Cash flow from
operations $2,337 $2,819
After discussing the calculationoffree cashflow to the firm and free cashflow to equity from historical information, Ballmer proceeds to explain the major approachesfor forecasting free cashflow. He focuseshis discussiononforecasting the componentsoffree cashflow as this method is more flexible. During his presentation, several of the analystsnotice that the
formula for forecasting free cashflow to equity doesnot include net borrowing. They bring this toBallmer's attention, and he
states that he will look into the formula and send out anupdated presentation after the meeting.
Aweek after the meeting, Jonathan Hodges approached Ballmer regarding twoissueshe had while applying free cashflow
based valuations. The first issue that Hodgeshad was that he calculated the equity value of a firm using bothfree cashflow to
equity based and dividend-based valuations and arrived at different values. The second issue that Hodges came acrosswas
the effect of a change in a firm's target leverage onFCFE. One of the firms that Hodgeswas analyzing may reduce leverage, and Hodgesneeds to knowif thiswill affect his valuation.
Regarding statements1 and 2, are Ballmer'sinterpretationsoffree cashflow to the firm (FCFF) and free cashflow to equity (FCFE)CORRECT?
No, neither interpretation is correct.
No, only one interpretationis correct.
Yes, bothinterpretations are correct.
Explanation
Free cashflow to the firm (FCFF)is the cashflows that are free toinvestors after cashoperating expenses (including taxes
but excluding interest expense), working capital investments, and fixed capital investmentshave been made. Free cashflow to
equity (FCFE)isFCFF lessinterest payments to bondholders and net borrowing from bondholders. (Study Session12, LOS
36.a)
IsBallmer's third statement regarding the computationoffirm value and equity value CORRECT?
ᅚ B) ᅞ C)
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Question #14 of 145
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Question #15 of 145
No, free cashflow to equity should be discounted at the required returnon equity. No, bothfree cashflow to the firm and free cashflow to equity should be discounted at the required rate of returnon equity.
Explanation
The value of a firm is the expected future free cashflow to the firm (FCFF) discounted at the firm'sweighted average cost of
capital (WACC). The value of the firm's equity is the expected future free cashflow to equity discounted at the required return on equity. (Study Session12, LOS 36.d)
Based onfigures1 and 2, the 20X2 free cashflow to equity (FCFE)for Ballmer's example firm is:
$1,010.
$1,693. $1,544.
Explanation
Free cashflow to equity (FCFE) can be computed as: FCFE = CFO − FCInv + net borrowing
Based on the figuresincluded in the example, fixed capital investment (FCInv)is −$223 (= $22,499 − $22,722) and net borrowing is −$1,016 (= $2,491 + $4,528 − $2,996 − $5,039).
FCFE is therefore:FCFE = $2,337 + $223 − $1,016 = $1,544. (Study Session12, LOS 36.d)
Whichof the following statements regarding forecasting FCFE using the componentsoffree cashflow method and net borrowing ismost accurate?
Investment in fixedcapital and net borrowing are assumed to offset each other.
Net income already accountsfor interest expense; therefore, net borrowing isnot
needed.
The target debt-to-asset ratio accountsfor the financing ofnewinvestment infixed capital and working capital.
Explanation
Whenforecasting FCFE, it is common to assume that a firm will maintain a target debt-to-asset ratiofor newinvestmentsin fixed capital and working capital. Based on this assumption, the formula for forecasting FCFE is:
FCFE = NI &£8722; [(1 − DR) × (FCInv − Dep)] − [(1 − DR) × WCInv]
By multiplying the fixed capital and working capital investments by one minus the target debt-to-asset ratio, you are left with
QuestionID:463183
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QuestionID:463225Should dividend-based and free cashflowfrom equity (FCFE) based valuations result in different equity valuesfor a firm?
Yes,dividend-basedvaluations wouldbe higher for firms with large,consistent
dividends.
Yes, the free cashflowfrom equity valuationwould be higher if there were a premium associated with control of the firm.
No, both modelsshould result in the same value.
Explanation
The ownership perspectivesof dividend-based and FCFE based valuations are different. Dividend-based valuations take the perspective of minority shareholders, while FCFE based valuations take the perspective of an acquirer whowill assume a controlling positionin the firm. Ifinvestorswere willing to pay a premium for a controlling positionin the firm, then the equity value computed under the FCFE approachwould be higher. (Study Session12, LOS 36.b)
Whichof the following statements regarding the effect a decrease in leverage hason a firm'sfree cashflowfrom equity (FCFE)ismost accurate?
FCFE is unaffectedby changes in leverage.
Current year FCFE increases, but future FCFE will be reduced.
Current year FCFE decreases, but future FCFE will be increased.
Explanation
Changesin leverage dohave a small effect onFCFE. A decrease in leverage will cause the current year FCFE to decrease through the repayment of debt. Future FCFE will be increased because interest expense will be lower. (Study Session12, LOS
36.g)
Athree-stagefree cashflowtothefirm (FCFF)istypically appropriatewhen:
growth is currently low and will move through a transitional stage to a final stage wherein growth exceeds the required rate of return.
growthis currently highand will movethroughatransitionalstagetoasteady-state growth rate.
therequired rateofreturnislessthanthe growthrateinthelaststage.
Explanation
ᅞ A) ᅚ B)
ᅞ C)
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Whichofthefollowing statementsregarding dividendsand free cashflowtoequity (FCFE)isleastaccurate?
FCFEcan be negative but dividends cannot.
Required returnsarehigherinFCFE discount modelsthanthey arein dividend discount models, sinceFCFE is more difficulttoestimate.
FCFE discount modelsusually resultinhigherequity valuesthan do dividend discount models (DDMs).
Explanation
AlthoughFCFE may be more difficulttoestimatethan dividends, therequired returnis based ontherisk faced by theshareholders, which would bethesameunder both models.
An analyst has prepared the following scenariosfor Schneider Inc.:
Scenario1Assumptions: Tax Rate is40%.
Weighted average cost of capital (WACC) = 12.0%.
Constant growth rate infree cashflow (FCF) = 3.0%.
Year 0, free cashflow to the firm (FCFF) = $30.0 million Target debt ratio = 10.0%.
Scenario 2 Assumptions: Tax Rate is40.0%.
Expenses before interest and taxes (EBIT), capital expenditures, and depreciationwill grow at 20.0% for the next three years.
After three years, the growthin EBITwill be 2.0%, and capital expenditure and depreciationwill offset eachother. Weighted average cost of capital (WACC) = 12.0%
Target debt ratio = 10.0%.
Scenario2FCFF(in$millions)
Y
ear
0
Y
ear
0
Y
ear
1
Y
ear
2
Y
ear
3
Y
ear
4
EBIT $45.00 $54.00 $64.80 $77.76 $79.70 Capital Expenditures 18.00 21.60 25.92 31.10
Depreciation 12.00 14.40 17.28 20.74 Changein Working Capital 6.00 6.30 6.60 7.20 7.20
FCFF 18.90 23.64 29.09 40.62
Other financial itemsfor Schneider Inc.:
Estimated market value of debt = $35.0 million Cost of debt = 5.0%
Question #1
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Giventheassumptions contained in Scenario1, the valueofthefirm ismostaccurately estimated as:
$343 million. $250 million. $333 million
Explanation
Under the stable growthFCFF model, the value of the firm = FCFF / (WACC − g ) = $30 million × (1.03) / (0.12 − 0.03) = $343.33 million.
(LOS 36.j)
In Scenario 2, the year0free cashflowtothefirm (FCFF)isclosestto
$15 million. $16 million. $27 million.
Explanation
FCFF = EBIT × (1 − tax rate) + Depreciation − Capital Expenditures − Change in Working Capital = 45.0 × (1 − 0.4) + 12.0 −
18.0 − 6.0 = 15.00. (LOS 36.d)
In Scenario 2, the present value of the terminal value isclosest to:
$289 million.
$347 million. $258 million.
Explanation
The terminal value is:FCFFfor year 4/(WACC- growth rate) = $40.62/(0.12 -0.02) = $406.22 millionin termsof year 3
dollars. The calculator inputs tosolve for the present value is:FV = $406.22, N = 3, I/Y = 12 solve for PV. PVis $289.14
Million. (LOS 36.e)
(LOS 36.e)
In Scenario 2, the value of the firm isclosest to:
$315 million.
ᅞ A) ᅚ B) ᅞ C)
Question #
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QuestionID:463217ᅚ A) ᅞ B) ᅞ C)
Questions #
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FCFE approach.The Dividend Discount approach.
FCFF approach.
Explanation
The dividend discount model is most appropriate for valuing a minority equity positionin a dividend-paying company. The free cashflow approach looks to the source of dividendsfrom the perspective of anowner that has control rather than directly at dividends.
Anincreaseinfinancialleveragewill causefree cashflowtoequity (FCFE)to:
increase in the year the borrowing occurred. decreaseinthe yearthe borrowing occurred.
decreaseorincrease, depending onits circumstances.
Explanation
Anincreaseinfinancialleveragewillincreasenet borrowing and, hence, increaseFCFE inthe yearthe borrowing occurred because: FCFE = FCFF- [interestexpense] (1-tax rate) + net borrowing.
Burcar-Eckhardt, a firm specializing in value investments, has been approached by the management of Overhaul Trucking,
Inc., to explore the possibility of taking the firm private via a management buyout. Overhaul'sstock hasstumbled recently, in
large part due to a suddenincrease inoil prices. Management considers this anopportune time to take the company private.
Burcar would be a minority investor in a group offriendly buyers.
Jaimie Carson, CFA, is a private equity portfolio manager withBurcar. He has been asked by Thelma Eckhardt, CFA, one of
the firm'sfounding partners, to take a look at Overhaul and come up with a strategy for valuing the firm. After analyzing Overhaul'sfinancial statements asof the most recent fiscal year-end (presented below), he determines that a valuationusing
Free CashFlow to Equity (FCFE)is most appropriate. He alsonotes that there were nosalesof PPE.
Ov
er
haul
Trucking,
Inc.
Income
Statement
April
30,
2005
(Millions
of
dollars)
2
005
2
00
6E
S
ale
s
300
.
0
3
2
0
.
0
G
r
oss
P
r
ofi
t
2
00
.
0
1
9
0
.
0
SG&
A
50
.
0
50
.
0
E
B
IT
8
0
.
0
6
0
.
0
In
tere
s
t
Exp
e
ns
e
30
.
0
3
4
.
0
T
a
x
e
s
(
at
35
p
er
c
e
n
t
)
17
.
5
9.
1
N
et In
c
o
m
e
3
2.
5
1
6
.
9
Overhaul
Trucking,
Inc.
Balance
Sheet
April
30,
2005
(Millions
of
dollars)
2
005
2
00
6E
Ca
sh
1
0
.
0
1
5
.
0
A
cc
o
u
n
t
s
R
e
c
e
i
v
a
b
le
50
.
0
55
.
0
G
r
oss
P
r
o
p
ert
y, P
la
n
t
& Eq
u
i
p.
4
00
.
0
4
8
0
.
0
A
cc
u
m
ulate
d
De
p
re
c
i
at
ion
(
1
6
0
.
0)
(2
4
0
.
0)
Total Assets
300
.
0
310
.
0
A
cc
o
u
n
t
s
P
a
y
a
b
le
50
.
0
7
0
.
0
L
on
g
-Ter
m
De
b
t
14
0
.
0
11
3
.
1
C
o
mm
on
S
t
o
ck
8
0
.
0
8
0
.
0
R
eta
in
e
d E
ar
nin
g
s
30
.
0
4
6.9
Total
L
ia
b
ilities
&
Eq
uit
y
300
.
0
310
.
0
Eckhardt agreeswithCarson's choice of valuation method, but her concernis Overhaul's debt ratio. Considerably higher than
the industry average, Eckhardt worries that the firm'sheavy leverage poses a risk to equity investors. Overhaul Trucking uses
a weighted average cost of capital of12% for capital budgeting, and Eckhardt wondersif that's realistic.
Eckhardt asksCarson to do a valuationof Overhaul in a high-growthscenario tosee ifoptimistic estimatesof the firm'snear -term growth rate can justify the required return to equity. For the high-growthscenario, she askshim tostart withhis 2006 estimate ofFCFE, growit at 30% per year for three years and then decrease the growth rate inFCFE in equal incrementsfor another three yearsuntil it hits the long-run growth rate of3% in 2012. Eckhardt tellsCarson that the returns to equity Burcar -Eckhardt would require are 20% until the completionof the high-growth phase, 15% during the three yearsof declining growth, and 10 percent thereafter. Eckhardt wants to knowwhat Burcar could afford to pay for a 15% stake in Overhaul in thishigh -growthscenario.
Carson assembles a fewspreadsheets and tells Eckhardt, "We could make a bid of just under $16 millionfor the stake in
Overhaul if the high-growthscenario playsout." Eckhardt worries, though, that the value of their bid is extremely sensitive to
the assumptionfor terminal growth, since in that scenario, the terminal value of the firm accountsfor slightly more than two -thirdsof the total value.
Carson agrees, and proposes doing a valuationunder a "sustained growth" scenario. His estimatesshow Overhaul growing FCFE by the following amounts:
2007
2008
2009
2010
2011
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In thisscenario, he would project sustained growthof 6% per year in 2012 and beyond. With the more stable growth patternin
cashflow, Eckhardt and Carson agree that the required return to equity could be cut to a more moderate 12%.
Carson also decides to try valuing the firm onFree CashFlow to the Firm (FCFF)using thissame 12% required return. Using a single-stage model on the estimated 2006 figures presented in the financial statements above, he comesup with a valuation of $1.08 billion.
Whichof the following isone of the differences betweenFCFE and FCFF? FCFF doesnot deduct:
workingcapital investment. operating expenses.
interest payments to bondholders.
Explanation
FCFFincludes the cash available to all of the firm'sinvestors, including bondholders. Therefore, interest payments to
bondholders are not removed from revenues to derive FCFF. FCFE isFCFF minusinterest payments to bondholders plusnet borrowingsfrom bondholders. (Study Session10, LOS 30.a)
Whichof the following is the leastlikely reasonfor Carson's decision touse FCFE in valuing Overhaul rather thanFCFF?
Overhaul's capital structure is stable.
FCFE is an easier and more straightforward calculation thanFCFF. Overhaul's debt ratioissignificantly higher than the industry average.
Explanation
The difference betweenFCFF and FCFE is related to capital structure and resulting interest expense. When the company's
capital structure is relatively stable, FCFE is easier and more straightforward touse. FCFFis generally the best choice when FCFE isnegative or the firm ishighly leveraged. The fact that Overhaul's debt ratioissignificantly higher than the industry average would argue against the use ofFCFE. Hence, thisis the least likely reason tofavor FCFE. (Study Session10, LOS
30.a)
Assuming that Carsonisusing May 1, 2005 ashis date of valuation, what is the estimated value of the firm's equity under the
scenario most suited tousing the two-stage FCFE method?
$129.5 million. $173.3 million. $125.2 million.
Explanation
Question #30 of 145
QuestionID:463303ᅞ A) ᅚ B) ᅞ C)
First, we need to calculate estimated FCFE in 2006. Since there were nosalesof PPE, we can calculate FCInv as the change
in Gross PPE.
FCFE = NI + NCC − FCInv − WCInv + Net Borrowing
= 16.9 + 80 − (480 − 400) − [(55 − 70) − (50 − 50)] + (113.1 − 140)
= 16.9 + 80 − 80 + 15 − 26.9 = $5 millionin 2006
Having calculated FCFE in 2006, we can calculate FCFE for 2007 through 2011using the growth rates provided:
200
7
2008
2009 20
1
0
20
11
G
r
o
w
t
h in
FCF
E
4
0.0%
1
5.
7
% 8.6% 9.
1
%
8.3%
I
mp
l
i
e
d
le
v
el
of
FCF
E
(in mi
ll
ions)
$
7
.0
$8.
1
$8.8
$9.6
$
1
0.
4
Now that we knowFCFE, we can discount future FCFE back to the present at the cost of equity.
In the first stage of the two-stage model, we determine the terminal value at the start of the constant growth period asfollows: Terminal Value = (10.4 × 1.06)/(0.12 − 0.06) = $183.733 million.
In the second stage, we discount FCFE for the first six years and the terminal value to the present.
Equity Value = [5.0 / (1.12)] + [7.0 / (1.12)] + [8.1 / (1.12)] + [8.8 / (1.12)] + [9.6 / (1.12)] + [(10.4 + 183.7333) / (1.12)] Equity Value = 4.46 + 5.58 + 5.77 + 5.59 + 5.45 + 98.35
Equity Value = $125.20 million
(Study Session12, LOS 36.j)
What is the expected growth rate inFCFF that Carson must have used to generate his valuationof $1.08 billion?
5%. 7%. 12%.
Explanation
Since Firm Value = FCFF / (WACC − g), we first need to determine FCFF , whichisFCFFin 2006:FCFF = NI + NCC + [Int × (1 − tax rate)] -FCInv − WCInv
= 16.9 + 80 + [34 × (1 − 0.35)] − (480 − 400) − [(55 − 70) − (50 − 50)] = 16.9 + 80 + 22.1 − 80 − (−15) = 54
Firm Value = FCFF / (WACC − g) 1080 = 54 / (0.12 − x)
[(1080)(0.12)] − 1080x = 54 129.6 − 1080x = 54 75.6 = 1080x
0.07 = x
1 2 3 4 5 6
1 1
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Question #34 of 145
QuestionID:463307ᅞ A) ᅞ B)
Once we have the discounted cashflowsfor each year, we need to calculate the terminal value. Terminal value will be: TV = (15.33)(1.03) / (0.10 − 0.03)
TV = 15.7899 / 0.07 TV = $225.57 million
Note that the required rate of returnused for the terminal value is the rate for the steady-growth period, whichis lower than
that used in the high-growth phase (stage)or the declining growth phase (stage two). We nowneed to discount terminal value back using the total discount factor for 2012: PVof terminal value = $225.57 million / [(1.20)(1.15)]
PVof terminal value = $71.53 million
Adding together the discounted cashflowsfor each year with the discounted terminal value, we have: Equity value = 4.17 + 4.51 + 4.89 + 5.30 + 5.57 + 5.43 + 4.86 + 71.53 = $106.26 million
Since the equity value of the firm is $106.26 million, Burcar should be willing to pay up to $106.26 × 0.15 = $15.94 millionfor a 15% stake in the firm. Since thisisslightly less than $16 million, Carson'sstatement is correct. The terminal value represents
($71.53 / $106.26) = 67.3% of the firm's present value, so Eckhardt'sstatement is also correct. (Study Session12, LOS 36.j)
In computing free cashflow, the mostsignificantnon-cashexpenseisusually:
depreciation.
capitalexpenditures. deferred taxes.
Explanation
Depreciationisusually thelargestnon-cashexpense.
Afirm has:
Free cashflowtothefirm = $4.0 million. Weighted average costof capital = 10%.
Total debt = $30.0 million.
Long-term expected growthrate = 5%.
Valueofthefirm = $50.00 pershare.
Whatwillhappentothe valueofthefirm iftheweighted average costof capitalincreasesto12%?
The value will remain the same.
The valuewillincrease.
ᅚ C)
Question #35 of 145
QuestionID:463310ᅞ A) ᅞ B) ᅚ C)
Question #3
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QuestionID:463202ᅞ A) ᅚ B) ᅞ C)
Question #37 of 145
QuestionID:463311ᅞ A) ᅞ B) ᅚ C)
The valuewill decrease.
Explanation
Everything else being constant, anincreaseintherelevantrequired rateofreturnshould decreasethe valueofthefirm.
Infive years, afirm isexpected to beoperating inastageofitslife cyclewhereinitsexpected growthrateis5%, indefinitely; itsrequired rateofreturnonequity is11%; itsweighted average costof capitalis 9%; and thefree cashflowtoequity in year 6 will be $5.25 per share. Whatisits projected terminal valueattheend of year5?
$131.25.
$51.93.
$87.50.
Explanation
Terminal value = FCFE / (k − g) = $5.25 / (0.11 − 0.05) = $87.50
Inforecasting free cashflowsitis commontoassumethatinvestmentinworking capital:
is greater than fixedcapital investment during a growth phase. will befinanced using thetarget debtratio.
willequalfixed capitalinvestment.
Explanation
Itisusually assumed thattheinvestmentinworking capitalwill befinanced consistentwiththetarget debtratio.
Terminal valuein multi-stagefree cashflow valuation modelsisoften calculated asthe present valueof:
a two-stage valuation model's price. free cashflow divided by the growthrate.
a constant growth model's priceasofthe beginning ofthelaststage.
Explanation
Questions #3
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Question #3
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QuestionID:463260ᅞ A) ᅚ B) ᅞ C)
Question #3
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QuestionID:463261Thefollowing informationwas collected from thefinancialstatementsofBankersIndustrialCorp (BIC)forthe yearended December31, 2013.
Earnings beforeinterestand taxes (EBIT) = $6.00 million.
Capitalexpenditures = $1.25 million.
Depreciationexpense = $0.63 million. Working capitaladditions = $0.59 million.
Costof debt = 10.50%.
Costofequity = 16.00%.
Stable growthrateforFCFF = 7.00%.
Stable growthrateforFCFE = 10.00%. Market valueof debt = $20.00 million. Book valueof debt = $22.50 million. Outstanding shares = 500,000.
Interestexpense = $2.00 million. NewDebt borrowing = $3.30 million.
Debtrepayment = $2.85 million.
Growthratesfortwo-stage growth modelforFCFE:
25.0% forYears1-3.
6.0% forYears4and thereafter.
BICis currently operating attheirtarget debtratioof40.00%. Thefirm'stax rateis40.00%.
Thefree cashflowtothefirm (FCFF)forthe current yearisclosestto:
$3.57 million.
$2.39 million. $2.31 million.
Explanation
TheFCFFforthe current yearis [$6.00m × (1 − 0.40)] + $0.63m − $1.25m − $0.59m = $2.39m.
(LOS 36.d)
ᅚ A) ᅞ B) ᅞ C)
Question #40 of 145
QuestionID:463262ᅞ A) ᅞ B) ᅚ C)
Question #41 of 145
QuestionID:463263ᅚ A) ᅞ B) ᅞ C)
Question #4
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QuestionID:46326412.1%.
16.0%.
13.8%.
Explanation
Theappropriate discountratetouseistheweighted average costof capital (WACC), and thisis WACC = (0.60 × 0.16) + [0.40 × 0.105 × (1 − 0.40)] = 12.12%.
(LOS 36.j)
Theestimated valueofthefirm isclosestto:
$38million.
$47 million. $50 million.
Explanation
The value ofBICusing a stable-growthFCFF model is $49.95 million, calculated as: FCFF = [$6.00m × (1 − 0.40)] + $0.63m − $1.25m − $0.59m. = $2.39m
WACC = (0.60 × 0.16) + [0.40 × 0.105 × (1 × 0.40)] = 12.12%. Estimated value = ($2.39m × 1.07) / (0.1212 − 0.07)= $49.95 million. (LOS 36.j)
If the estimated value of the firm is $50.0 million, the value per share ofBICstock should be closest to:
$60. $28. $30.
Explanation
Equity value = Firm value - market value of debt; $50 million- $20 million = $30 million: $30,000,000/500,000 = $60.00 per share.
(LOS 36.j)
If the estimated value of the free cash to the firm (FCFF)for year 0is $2.4 million, the value per share ofBICstock, based on
ᅚ A) ᅞ B) ᅞ C)
Question #43 of 145
QuestionID:463265ᅚ A) ᅞ B) ᅞ C)
Question #44 of 145
QuestionID:463174ᅞ A) ᅞ B) ᅚ C)
$61 $55
$39
Explanation
FCFE = FCFF-Interest expense × (1 − tax rate) + Net borrowing = $2.40 million- [$2.00 million × (1 − 0.40)] + $3.30 million − $2.85 million = $1.65 million.
The value of equity is: [$1.65 million × (1+0.10) ] /(0.16 − 0.10) = $30.25 million. On a per share basis: $30.25 million/500,000 = $60.50
(LOS 36.j)
The current market price ofBICis $62.50 per share, and the current year'sFCFE is $1.75 million. Using a two-stage growth
model tofind the estimated the firm's value, the current market price BICis most accurately described as:
overvalued. fairly valued. undervalued.
Explanation
FCFE = FCFF − Interest expense × (1 − T) + New borrowing.
Year 0 1 2 3 4
Growthrate 25.0% 25.0% 25.0% 6.0% FCFE in
mil$ $1.750$2.188 $2.734$3.418 $3.623
The terminal value is $3,623/(0.16 -0.06) = $36,230 million. The calculator inputs:CF0 = 0, CF1 = $2,188, CF2 = $2,734, CF3
= $3,418 + $36,230 = $39,648, I = 16, NPV = $29.319 million.
Per share price is $29,319,000/500,000 = $58.64. The stock appears to be overvalued at the current market price of $62.50
per share, asour estimated value of $58.64suggests that the market price is toohigh. (LOS 36.m)
The difference betweenfree cashflowtoequity (FCFE)and free cashflowtothefirm (FCFF)is:
before-tax interest and net borrowing.
earnings beforeinterestand taxes (EBIT)lesstaxes. after-tax interestand net borrowing.
Question #45 of 145
QuestionID:463222ᅞ A) ᅚ B) ᅞ C)
Question #4
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QuestionID:463230ᅞ A) ᅞ B) ᅚ C)
Question #47 of 145
QuestionID:463258ᅞ A)
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FCFE = FCFF- [interestexpense] (1-tax rate) + net borrowing.
Therepurchaseof 20% ofafirm'soutstanding commonshareswill causefree cashflowtothefirm (FCFF)to:
decrease.
remainthesame. increase.
Explanation
Sharerepurchasesareauseoffree cashflows, notasource. FCFFis cashflowthatisavailabletoall capitalsuppliers. Noticethe conspicuousabsenceofrepurchasesinthefollowing:FCFF = CFO + Int (1-tax rate)-FCInv.
Whichofthefollowing free cashflowtothefirm (FCFF) modelsismostsuited toanalyzefirmsthatare growing atafasterratethanthe overalleconomy?
High growth FCFF model.
No growthFCFF model.
Two-stageFCFF model.
Explanation
Thetwo-stageFCFF modelis mostsuited foranalyzing firms growing ataratefasterthantheoveralleconomy. Thetwo-stage model assumesahighrateof growthforaninitial period, followed by animmediate jump toa constant, stable growthrate.
The value ofstock under the two-stage FCFE model will be equal to:
present value (PV) of FCFEduring the extraordinarygrowth and transitional
periods plus the PV of terminal value.
present value (PV)ofFCFE during the extraordinary growth period plus the terminal value.
present value (PV)ofFCFE during the extraordinary growth period plus the PVof
terminal value.
Explanation
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QuestionID:463308ᅞ A) ᅚ B) ᅞ C)
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QuestionID:463236ᅞ A) ᅚ B) ᅞ C)
Question #50 of 145
QuestionID:463193ᅞ A) ᅚ B) ᅞ C) Afirm has:
Free cashflowtoequity = $4.0 million.
Costofequity = 12%.
Long-term expected growthrate = 5%.
Valueofequity pershare = $57.14 pershare.
Whatwillhappentothe valueofthefirm iffree cashflowtoequity decreasesto $3.2 million?
There is insufficient information to tell. The valuewill decrease.
The valuewillincrease.
Explanation
Everything else being constant, a decreaseinfree cashflowtoequity should decreasethe valueofthefirm.
Whichofthefollowing free cashflowtoequity (FCFE) modelsismostsuited toanalyzefirmsinanindustry withsignificant barriersto entry?
Stable Growth FCFEModel.
Two-stageFCFE Model.
FCFE Perpetuity Model.
Explanation
Thetwo-stageFCFE modelis mostsuited foranalyzing firmsinhigh growththatwill maintainthat growthforaspecific period, suchas firmswith patentsorfirmsinanindustry withsignificant barrierstoentry.
Whichof the following itemsis NOTsubtracted from the net income to calculate free cashflow to equity (FCFE)?
increase in accounts receivable. Interest payments to bondholders. Increase infixed assets.
Explanation
