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TestID:7441130
Question#1of145
QuestionID:463221
AnanalysthaspreparedthefollowingscenariosforSchneider,Inc.:
Scenario1Assumptions:
Taxrateis40%.
Weightedaveragecostofcapital(WACC)=12%.
Constantgrowthrateinfreecashflow=3%.
Lastyear,freecashflowtothefirm(FCFF)=$30.
Targetdebtratio=10%.
Scenario2Assumptions:
Taxrateis40%.
Expensesbeforeinterestandtaxes(EBIT),capitalexpenditures,anddepreciationwillgrowat15%forthenextthree
years.
Afterthreeyears,thegrowthinEBITwillbe2%,andcapitalexpenditureanddepreciationwilloffseteachother.
WACCduringhighgrowthstage=20%.
WACCduringstablegrowthstage=12%.
Targetdebtratio=10%.
Year0
Scenario2FCFF
(last
Year1
Year2
Year3
Year4
$15.00
$17.25
$19.84
$22.81
$23.27
CapitalExpenditures
6.00
6.90
7.94
9.13
Depreciation
4.00
4.60
5.29
6.08
ChangeinWorkingCapital
2.00
2.10
2.20
2.40
2.40
5.95
7.06
8.25
11.56
year)
EBIT
FCFF
AssumingthatSchneider,Inc.,slightlyincreasesitsfinancialleverage,whatshouldhappentoitsfirmvalue?Thefirmvalue
should:
A) increaseduetotheadditionalvalueofinteresttaxshields.
B) notchangebecausefinancialleveragehasnorelationshipwithfirmvalue.
C) declineduetotheincreaseinrisk.
Explanation
Forsmallchangesinleverage,theadditionalvalueaddedbytheinteresttaxshieldswillmorethanoffsettheadditionalriskofbankruptcy
/financialdistress.Giventhetaxadvantageofdebt,thefirm'sWACCshoulddecline,notincreasewithsmallchangesinleverage.
Questions#27of145
HarrisburgTireCompany(HTC)forecaststhefollowingfor2013:
Earnings(netincome)=$600M.
Dividends=$120M.
Interestexpense=$400M.
Taxrate=40.0%.
Depreciation=$500M.
Capitalspending=$800M.
Totalassets=$10B(bookvalueandmarketvalue).
Debt=$4B(bookvalueandmarketvalue).
Equity=$6B(bookvalueandmarketvalue).
Targetdebttoassetratio=0.40.
Sharesoutstanding=2.0billion
Thefirm'sworkingcapitalneedsarenegligible,andHTCplanstocontinuetooperatewiththecurrentcapitalstructure.Thetireindustry
demandishighlydependentondemandfornewautomobiles.Individualcompaniesintheindustrydon'thavemuchinfluenceonthe
designofautomobilesandhaveverylittleabilitytoaffecttheirbusinessenvironment.Thedemandfornewautomobilesishighlycyclical
butdemandforecasterrorstendtobelow.
Question#2of145
QuestionID:463279
Thefirm'searningsgrowthrateismostaccuratelyestimatedas:
A) 6.4%.
B) 4.8%.
C) 8.0%.
Explanation
Thefirm'sestimatedearningsgrowthrateistheproductofitsretentionratioandROE:
g=RR(ROE)=[(600120)/600](600/6000)=0.08(LOS35.o)
Question#3of145
The2013forecastedfreecashflowtoequityis:
A) $300M.
B) $420M.
C) $340M.
Explanation
Sinceworkingcapitalneedsarenegligible,thefreecashflowtoequityis:
FCFE=Netincome[1DR)][FCInvDepreciation][(1DR)WCInv]
FCFE=600M[10.4](800M500M)=420M
where:
DR=targetdebttoassetratio(LOS36.d)
QuestionID:463280
Question#4of145
QuestionID:463281
Ifthetotalmarketvalueofequityis$6.0billionandthegrowthrateis8.0%,thecostofequitybasedonthestablegrowthFCFEmodelis
closestto:
A) 15.0%.
B) 7.6%.
C) 15.6%.
Explanation
Valueofequity=FCFE1/(Costofequitygrowthrate)so$6,000=[$420(1.08)]/(Costofequity0.08)
(Costofequity0.08)$6,000=$453.6
Costofequity0.08=0.0756
Costofequity=0.1556=15.56%(LOS36.j)
Question#5of145
QuestionID:463282
ThebetaforHTCis1.056,theriskfreerateis5.0%andthemarketriskpremiumis10.0%.TheweightedaveragecostofcapitalforHTC
isclosestto:
A) 11.74%.
B) 13.34%.
C) 15.56%.
Explanation
Costofequity=rf+(rmrf)=0.05+1.056(0.10)=0.05+0.1056=0.1556
Thebestapproximationforcostofdebtistheinterestexpensedividedbythemarketvalueofthedebt.
Costofdebt=Interestexpense/marketvalueofdebt=$400million/$4.0billion=0.10
WACC=wdrd(1t)+were=0.400.10(10.40)+0.600.1556=0.1174(LOS36.j)
Question#6of145
QuestionID:463283
ThemostappropriatestrategyformulationstyleforHTCis:
A) Adaptive
B) Classical
C) Shaping
Explanation
Industrydemandiscyclicalbutforecasterrorstendtobelowindicatingpredictablebusinessenvironment.Wearealsogiventhat
malleabilityislow.HenceClassicalstylewouldbemostappropriate.(LOS33.c)
Question#7of145
QuestionID:463284
FCFEfor2013is$400.0millionandHTCtookonanadditionaldebtof$40.0millionwhilerepayingexistingdebtof$60.0
million.ThegrowthrateforFCFFis5.0%andtheWACCis11.5%.Thevalueofthefirmcalculatedusingthestablegrowth
modelismostaccuratelydescribedas:
A) lessthanthemarketvalueofthefirmby$3.3billion.
B) lessthanthemarketvalueofthefirmby$7.5billion.
C) greaterthanthemarketvalueofthefirmby$0.7billion.
Explanation
FCFF=FCFE+Interestexpense(1t)netborrowing=$400million+$400million(10.40)($40million$60million)
=$660million.
Valueofthefirm=[$660million(1.05)]/(0.1150.05)=$10.662billion.Thisisadifferenceof$0.662billioncomparedtothe
$10.0billioncurrentmarketvalue.(LOS36.j,m)
Question#8of145
QuestionID:463199
Afirmcurrentlyhassalespershareof$10.00,andexpectssalestogrowby25%nextyear.Thenetprofitmarginisexpectedtobe15%.
Fixedcapitalinvestmentnetofdepreciationisprojectedtobe65%ofthesalesincrease,andworkingcapitalrequirementsare15%ofthe
projectedsalesincrease.Debtwillfinance45%oftheinvestmentsinnetcapitalandworkingcapital.Thecompanyhasan11%required
rateofreturnonequity.Whatisthefirm'sexpectedfreecashflowtoequity(FCFE)persharenextyearundertheseassumptions?
A) $0.38.
B) $1.88.
C) $0.77.
Explanation
FCFE=netprofitNetFCInvWCInv+DebtFin=$1.88$1.630.38+0.90=0.77
Question#9of145
QuestionID:463244
InusingFCFEmodels,theassumptionofgrowthshouldbe:
A) independentfromtheassumptionsofothervariables.
B) onlyconsistentwiththeassumptionsofcapitalspendinganddepreciation.
C) consistentwithassumptionsofothervariables.
Explanation
Theassumptionofgrowthshouldbeconsistentwithassumptionsaboutothervariables.Netcapitalexpenditures(capital
expendituresminusdepreciation)andbeta(risk)usedtocalculaterequiredrateofreturnshouldbeconsistentwithassumed
growthrate.
Question#10of145
WhichofthefollowingstatementsaboutthethreestageFCFEmodelismostaccurate?
A) Thereisafinalphasewhengrowthratestartstodecline.
QuestionID:463232
B) Thereisatransitionperiodwherethegrowthratedeclines.
C) Thereisatransitionperiodwherethegrowthrateisstable.
Explanation
InthethreestageFCFEmodel,thereisaninitialphaseofhighgrowth,atransitionperiodwherethegrowthratedeclines,and
asteadystateperiodwheregrowthisstable.
Questions#1116of145
MichaelBallmerisanequityanalystwithNewHorizonResearch.Thefirmhashistoricallyreliedondividendandresidual
incomevaluationmodelstovalueequity,butthefirm'sdirectorofresearch,DougLeads,hasdecidedthatthefirmneedsto
incorporatefreecashflowvaluationsintoitspractices.Therefore,LeadsdecidestosendBallmertoaseminaronfreecash
flowvaluation.
Uponhisreturnfromtheconvention,Ballmerisexcitedtosharehisnewfoundknowledgewithhiscoworkers.Ballmerisasked
togiveadebriefingtoNewHorizon'steamofequityanalysts,wherehemakesthefollowingstatements:
Statement
1:
Freecashflowtothefirmistheamountofthefirm'scashflowthatis
freeforthefirmtouseinmakinginvestmentsaftercashoperating
expenseshavebeencovered.
Statement
2:
Freecashflowtoequity,then,istheamountofthefirm'scashflow
thatisfreeforequityholdersaftercoveringcashoperatingexpenses,
workingcapitalandfixedcapitalinvestments,interestprincipal
paymentstobondholders,andrequireddividedpayments.
Statement
3:
Oneofthebenefitsoffreecashflowvaluationisthatthevalueofthe
firmandthevalueofequitycanbefoundbydiscountingfreecash
flowtothefirmandfreecashflowtoequity,respectively,bythe
WACC.
Aspartofhispresentation,Ballmerincludesashortexampleofhowtocalculatefreecashflowtoequity.Thefiguresfromhis
exampleareincludedbelow.
Figure1:ExampleBalanceSheet
20X2
20X1
Cash
$632
$245
Accountsreceivable
$208
$105
Inventory
$8,249
$8,209
Currentassets
$9,089
$8,559
GrossPPE
$22,499 $22,722
Accumulateddepreciation
($3,251) ($2,875)
Totalassets
$28,337 $28,406
Accountspayable
$4,864
$4,543
Shorttermdebt
$2,491
$2,996
Currentliabilities
$7,355
$7,539
Longtermdebt
$4,528
$5,039
Commonstock
$729
$735
Retainedearnings
$15,725 $15,093
Totalliabilitiesandowner's
equity
$28,337 $28,406
Figure2:ExampleCashFlowFrom
Operations
20X2
Netincome
20X1
$1,783 $2,195
Depreciation
$376
$267
WCInv
($178)
$357
Cashflowfrom
operations
$2,337 $2,819
Afterdiscussingthecalculationoffreecashflowtothefirmandfreecashflowtoequityfromhistoricalinformation,Ballmer
proceedstoexplainthemajorapproachesforforecastingfreecashflow.Hefocuseshisdiscussiononforecastingthe
componentsoffreecashflowasthismethodismoreflexible.Duringhispresentation,severaloftheanalystsnoticethatthe
formulaforforecastingfreecashflowtoequitydoesnotincludenetborrowing.TheybringthistoBallmer'sattention,andhe
statesthathewilllookintotheformulaandsendoutanupdatedpresentationafterthemeeting.
Aweekafterthemeeting,JonathanHodgesapproachedBallmerregardingtwoissueshehadwhileapplyingfreecashflow
basedvaluations.ThefirstissuethatHodgeshadwasthathecalculatedtheequityvalueofafirmusingbothfreecashflowto
equitybasedanddividendbasedvaluationsandarrivedatdifferentvalues.ThesecondissuethatHodgescameacrosswas
theeffectofachangeinafirm'stargetleverageonFCFE.OneofthefirmsthatHodgeswasanalyzingmayreduceleverage,
andHodgesneedstoknowifthiswillaffecthisvaluation.
Question#11of145
QuestionID:463179
Regardingstatements1and2,areBallmer'sinterpretationsoffreecashflowtothefirm(FCFF)andfreecashflowtoequity
(FCFE)CORRECT?
A) No,neitherinterpretationiscorrect.
B) No,onlyoneinterpretationiscorrect.
C) Yes,bothinterpretationsarecorrect.
Explanation
Freecashflowtothefirm(FCFF)isthecashflowsthatarefreetoinvestorsaftercashoperatingexpenses(includingtaxes
butexcludinginterestexpense),workingcapitalinvestments,andfixedcapitalinvestmentshavebeenmade.Freecashflowto
equity(FCFE)isFCFFlessinterestpaymentstobondholdersandnetborrowingfrombondholders.(StudySession12,LOS
36.a)
Question#12of145
IsBallmer'sthirdstatementregardingthecomputationoffirmvalueandequityvalueCORRECT?
A) Yes.
QuestionID:463180
B) No,freecashflowtoequityshouldbediscountedattherequiredreturnonequity.
C) No,bothfreecashflowtothefirmandfreecashflowtoequityshouldbediscounted
attherequiredrateofreturnonequity.
Explanation
Thevalueofafirmistheexpectedfuturefreecashflowtothefirm(FCFF)discountedatthefirm'sweightedaveragecostof
capital(WACC).Thevalueofthefirm'sequityistheexpectedfuturefreecashflowtoequitydiscountedattherequiredreturn
onequity.(StudySession12,LOS36.d)
Question#13of145
QuestionID:463181
Basedonfigures1and2,the20X2freecashflowtoequity(FCFE)forBallmer'sexamplefirmis:
A) $1,010.
B) $1,693.
C) $1,544.
Explanation
Freecashflowtoequity(FCFE)canbecomputedas:
FCFE=CFOFCInv+netborrowing
Basedonthefiguresincludedintheexample,fixedcapitalinvestment(FCInv)is$223(=$22,499$22,722)andnet
borrowingis$1,016(=$2,491+$4,528$2,996$5,039).
FCFEistherefore:FCFE=$2,337+$223$1,016=$1,544.(StudySession12,LOS36.d)
Question#14of145
QuestionID:463182
WhichofthefollowingstatementsregardingforecastingFCFEusingthecomponentsoffreecashflowmethodandnet
borrowingismostaccurate?
A) Investmentinfixedcapitalandnetborrowingareassumedtooffseteachother.
B) Netincomealreadyaccountsforinterestexpensetherefore,netborrowingisnot
needed.
C) Thetargetdebttoassetratioaccountsforthefinancingofnewinvestmentinfixed
capitalandworkingcapital.
Explanation
WhenforecastingFCFE,itiscommontoassumethatafirmwillmaintainatargetdebttoassetratiofornewinvestmentsin
fixedcapitalandworkingcapital.Basedonthisassumption,theformulaforforecastingFCFEis:
FCFE=NI&8722[(1DR)(FCInvDep)][(1DR)WCInv]
Bymultiplyingthefixedcapitalandworkingcapitalinvestmentsbyoneminusthetargetdebttoassetratio,youareleftwith
theinvestmentamountlesstheamountfinancedbydebt,whichisthenetborrowingamount.Therefore,thisformulaaccounts
fornetborrowingthroughthetargetdebttoassetratio.(StudySession12,LOS36.e)
Question#15of145
QuestionID:463183
Shoulddividendbasedandfreecashflowfromequity(FCFE)basedvaluationsresultindifferentequityvaluesforafirm?
A) Yes,dividendbasedvaluationswouldbehigherforfirmswithlarge,consistent
dividends.
B) Yes,thefreecashflowfromequityvaluationwouldbehigheriftherewereapremium
associatedwithcontrolofthefirm.
C) No,bothmodelsshouldresultinthesamevalue.
Explanation
TheownershipperspectivesofdividendbasedandFCFEbasedvaluationsaredifferent.Dividendbasedvaluationstakethe
perspectiveofminorityshareholders,whileFCFEbasedvaluationstaketheperspectiveofanacquirerwhowillassumea
controllingpositioninthefirm.Ifinvestorswerewillingtopayapremiumforacontrollingpositioninthefirm,thentheequity
valuecomputedundertheFCFEapproachwouldbehigher.(StudySession12,LOS36.b)
Question#16of145
QuestionID:463184
Whichofthefollowingstatementsregardingtheeffectadecreaseinleveragehasonafirm'sfreecashflowfromequity
(FCFE)ismostaccurate?
A) FCFEisunaffectedbychangesinleverage.
B) CurrentyearFCFEincreases,butfutureFCFEwillbereduced.
C) CurrentyearFCFEdecreases,butfutureFCFEwillbeincreased.
Explanation
ChangesinleveragedohaveasmalleffectonFCFE.AdecreaseinleveragewillcausethecurrentyearFCFEtodecrease
throughtherepaymentofdebt.FutureFCFEwillbeincreasedbecauseinterestexpensewillbelower.(StudySession12,LOS
36.g)
Question#17of145
QuestionID:463243
Athreestagefreecashflowtothefirm(FCFF)istypicallyappropriatewhen:
A) growthiscurrentlylowandwillmovethroughatransitionalstagetoafinalstage
whereingrowthexceedstherequiredrateofreturn.
B) growthiscurrentlyhighandwillmovethroughatransitionalstagetoasteadystategrowth
rate.
C) therequiredrateofreturnislessthanthegrowthrateinthelaststage.
Explanation
ThethreestagemodelusingeitherFCFEorFCFFtypicallyassumesthatgrowthiscurrentlyhighandwillmovethroughatransitional
stagetoasteadystategrowthrate.Multistagemodelsassumethattherequiredrateofreturnexceedsthegrowthrateinthelaststage.
Question#18of145
QuestionID:463225
Whichofthefollowingstatementsregardingdividendsandfreecashflowtoequity(FCFE)isleastaccurate?
A) FCFEcanbenegativebutdividendscannot.
B) RequiredreturnsarehigherinFCFEdiscountmodelsthantheyareindividenddiscount
models,sinceFCFEismoredifficulttoestimate.
C) FCFEdiscountmodelsusuallyresultinhigherequityvaluesthandodividenddiscountmodels
(DDMs).
Explanation
AlthoughFCFEmaybemoredifficulttoestimatethandividends,therequiredreturnisbasedontheriskfacedbytheshareholders,which
wouldbethesameunderbothmodels.
Questions#1924of145
AnanalysthaspreparedthefollowingscenariosforSchneiderInc.:
Scenario1Assumptions:
TaxRateis40%.
Weightedaveragecostofcapital(WACC)=12.0%.
Constantgrowthrateinfreecashflow(FCF)=3.0%.
Year0,freecashflowtothefirm(FCFF)=$30.0million
Targetdebtratio=10.0%.
Scenario2Assumptions:
TaxRateis40.0%.
Expensesbeforeinterestandtaxes(EBIT),capitalexpenditures,anddepreciationwillgrowat20.0%forthenextthree
years.
Afterthreeyears,thegrowthinEBITwillbe2.0%,andcapitalexpenditureanddepreciationwilloffseteachother.
Weightedaveragecostofcapital(WACC)=12.0%
Targetdebtratio=10.0%.
Scenario2FCFF(in$millions)
EBIT
CapitalExpenditures
18.00
21.60
25.92
31.10
Depreciation
12.00
14.40
17.28
20.74
ChangeinWorkingCapital
6.00
6.30
6.60
7.20
7.20
18.90
23.64
29.09
40.62
FCFF
OtherfinancialitemsforSchneiderInc.:
Estimatedmarketvalueofdebt=$35.0million
Costofdebt=5.0%
Sharesoutstanding=20million.
Question#19of145
QuestionID:463248
GiventheassumptionscontainedinScenario1,thevalueofthefirmismostaccuratelyestimatedas:
A) $343million.
B) $250million.
C) $333million
Explanation
UnderthestablegrowthFCFFmodel,thevalueofthefirm=FCFF 1/(WACCgn)=$30million(1.03)/(0.120.03)=
$343.33million.
(LOS36.j)
Question#20of145
QuestionID:463249
InScenario2,theyear0freecashflowtothefirm(FCFF)isclosestto
A) $15million.
B) $16million.
C) $27million.
Explanation
FCFF=EBIT(1taxrate)+DepreciationCapitalExpendituresChangeinWorkingCapital=45.0(10.4)+12.0
18.06.0=15.00.
(LOS36.d)
Question#21of145
QuestionID:463250
InScenario2,thepresentvalueoftheterminalvalueisclosestto:
A) $289million.
B) $347million.
C) $258million.
Explanation
Theterminalvalueis:FCFFforyear4/(WACCgrowthrate)=$40.62/(0.120.02)=$406.22millionintermsofyear3
dollars.Thecalculatorinputstosolveforthepresentvalueis:FV=$406.22,N=3,I/Y=12solveforPV.PVis$289.14
Million.(LOS36.e)
(LOS36.e)
Question#22of145
InScenario2,thevalueofthefirmisclosestto:
A) $315million.
QuestionID:463251
B) $346million.
C) $321million.
Explanation
ThevalueofthefirmisthepresentvalueofYear13plustheterminalvalue.Theterminalvalueis:FCFFforyear4/(WACC
growthrate)=$40.62/(0.120.02)=$406.22millionintermsofyear3dollars.ThecalculatorinputstosolveNPVforthe
valueofthefirmis:CF0=$0,CF1=$18.90,CF2=$23.64,CF3=$29.09+$406.22=$435.31,I=12.NPV=$345.57million.
(LOS36.d)
Question#23of145
QuestionID:463252
ThecostofequityforSchneiderInc.isclosestto:
A) 13.0%.
B) 5.8%.
C) 11.3%
Explanation
TheweightedaveragecostofcapitalformulaisWACC=wdrd(1t)+were.Theweightofdebtis10.0%theweightof
equitymustbe90.0%.
0.12=0.100.05(10.40)+0.90re
0.1200.003=0.90re
0.117/0.9=re
re=13.0%
(LOS36.j)
Question#24of145
QuestionID:463253
ThemarketvalueofScheiderInc.'sstockis:
A) $17.50pershare.
B) $15.75pershare
C) $31.50pershare.
Explanation
Theestimatedmarketvalueofdebtis$35million,whichrepresents10.0%ofthevalueofthefirm.Theother90.0%isthe
valueofequityor$315million.$315million/20millionshares=$15.75pershare.
(LOS36.j)
Question#25of145
QuestionID:463185
Ananalystisperforminganequityvaluationforaminorityequitypositioninadividendpayingmultinational.Theappropriate
modelforthisanalysisismostlikely:
A) FCFEapproach.
B) TheDividendDiscountapproach.
C) FCFFapproach.
Explanation
Thedividenddiscountmodelismostappropriateforvaluingaminorityequitypositioninadividendpayingcompany.Thefree
cashflowapproachlookstothesourceofdividendsfromtheperspectiveofanownerthathascontrolratherthandirectlyat
dividends.
Question#26of145
QuestionID:463217
Anincreaseinfinancialleveragewillcausefreecashflowtoequity(FCFE)to:
A) increaseintheyeartheborrowingoccurred.
B) decreaseintheyeartheborrowingoccurred.
C) decreaseorincrease,dependingonitscircumstances.
Explanation
Anincreaseinfinancialleveragewillincreasenetborrowingand,hence,increaseFCFEintheyeartheborrowingoccurredbecause:
FCFE=FCFF[interestexpense](1taxrate)+netborrowing.
Questions#2732of145
BurcarEckhardt,afirmspecializinginvalueinvestments,hasbeenapproachedbythemanagementofOverhaulTrucking,
Inc.,toexplorethepossibilityoftakingthefirmprivateviaamanagementbuyout.Overhaul'sstockhasstumbledrecently,in
largepartduetoasuddenincreaseinoilprices.Managementconsidersthisanopportunetimetotakethecompanyprivate.
Burcarwouldbeaminorityinvestorinagroupoffriendlybuyers.
JaimieCarson,CFA,isaprivateequityportfoliomanagerwithBurcar.HehasbeenaskedbyThelmaEckhardt,CFA,oneof
thefirm'sfoundingpartners,totakealookatOverhaulandcomeupwithastrategyforvaluingthefirm.Afteranalyzing
Overhaul'sfinancialstatementsasofthemostrecentfiscalyearend(presentedbelow),hedeterminesthatavaluationusing
FreeCashFlowtoEquity(FCFE)ismostappropriate.HealsonotesthattherewerenosalesofPPE.
OverhaulTrucking,Inc.
IncomeStatement
April30,2005
(Millionsofdollars)
2005 2006E
Sales
300.0
320.0
GrossProfit
200.0
190.0
SG&A
50.0
50.0
Depreciation
70.0
80.0
EBIT
80.0
60.0
InterestExpense
30.0
34.0
Taxes(at35percent)
17.5
9.1
NetIncome
32.5
16.9
OverhaulTrucking,Inc.
BalanceSheet
April30,2005
(Millionsofdollars)
2005
2006E
Cash
10.0
15.0
AccountsReceivable
50.0
55.0
GrossProperty,Plant&Equip.
400.0
480.0
AccumulatedDepreciation
(160.0) (240.0)
TotalAssets
300.0
310.0
AccountsPayable
50.0
70.0
LongTermDebt
140.0
113.1
CommonStock
80.0
80.0
RetainedEarnings
30.0
46.9
TotalLiabilities&Equity
300.0
310.0
EckhardtagreeswithCarson'schoiceofvaluationmethod,butherconcernisOverhaul'sdebtratio.Considerablyhigherthan
theindustryaverage,Eckhardtworriesthatthefirm'sheavyleverageposesarisktoequityinvestors.OverhaulTruckinguses
aweightedaveragecostofcapitalof12%forcapitalbudgeting,andEckhardtwondersifthat'srealistic.
EckhardtasksCarsontodoavaluationofOverhaulinahighgrowthscenariotoseeifoptimisticestimatesofthefirm'snear
termgrowthratecanjustifytherequiredreturntoequity.Forthehighgrowthscenario,sheaskshimtostartwithhis2006
estimateofFCFE,growitat30%peryearforthreeyearsandthendecreasethegrowthrateinFCFEinequalincrementsfor
anotherthreeyearsuntilithitsthelongrungrowthrateof3%in2012.EckhardttellsCarsonthatthereturnstoequityBurcar
Eckhardtwouldrequireare20%untilthecompletionofthehighgrowthphase,15%duringthethreeyearsofdeclininggrowth,
and10percentthereafter.EckhardtwantstoknowwhatBurcarcouldaffordtopayfora15%stakeinOverhaulinthishigh
growthscenario.
CarsonassemblesafewspreadsheetsandtellsEckhardt,"Wecouldmakeabidofjustunder$16millionforthestakein
Overhaulifthehighgrowthscenarioplaysout."Eckhardtworries,though,thatthevalueoftheirbidisextremelysensitiveto
theassumptionforterminalgrowth,sinceinthatscenario,theterminalvalueofthefirmaccountsforslightlymorethantwo
thirdsofthetotalvalue.
Carsonagrees,andproposesdoingavaluationundera"sustainedgrowth"scenario.HisestimatesshowOverhaulgrowing
FCFEbythefollowingamounts:
2007
2008
2009
2010
2011
9.1%
8.3%
Inthisscenario,hewouldprojectsustainedgrowthof6%peryearin2012andbeyond.Withthemorestablegrowthpatternin
cashflow,EckhardtandCarsonagreethattherequiredreturntoequitycouldbecuttoamoremoderate12%.
CarsonalsodecidestotryvaluingthefirmonFreeCashFlowtotheFirm(FCFF)usingthissame12%requiredreturn.Using
asinglestagemodelontheestimated2006figurespresentedinthefinancialstatementsabove,hecomesupwithavaluation
of$1.08billion.
Question#27of145
QuestionID:463300
WhichofthefollowingisoneofthedifferencesbetweenFCFEandFCFF?FCFFdoesnotdeduct:
A) workingcapitalinvestment.
B) operatingexpenses.
C) interestpaymentstobondholders.
Explanation
FCFFincludesthecashavailabletoallofthefirm'sinvestors,includingbondholders.Therefore,interestpaymentsto
bondholdersarenotremovedfromrevenuestoderiveFCFF.FCFEisFCFFminusinterestpaymentstobondholdersplusnet
borrowingsfrombondholders.(StudySession10,LOS30.a)
Question#28of145
QuestionID:463301
WhichofthefollowingistheleastlikelyreasonforCarson'sdecisiontouseFCFEinvaluingOverhaulratherthanFCFF?
A) Overhaul'scapitalstructureisstable.
B) FCFEisaneasierandmorestraightforwardcalculationthanFCFF.
C) Overhaul'sdebtratioissignificantlyhigherthantheindustryaverage.
Explanation
ThedifferencebetweenFCFFandFCFEisrelatedtocapitalstructureandresultinginterestexpense.Whenthecompany's
capitalstructureisrelativelystable,FCFEiseasierandmorestraightforwardtouse.FCFFisgenerallythebestchoicewhen
FCFEisnegativeorthefirmishighlyleveraged.ThefactthatOverhaul'sdebtratioissignificantlyhigherthantheindustry
averagewouldargueagainsttheuseofFCFE.Hence,thisistheleastlikelyreasontofavorFCFE.(StudySession10,LOS
30.a)
Question#29of145
QuestionID:463302
AssumingthatCarsonisusingMay1,2005ashisdateofvaluation,whatistheestimatedvalueofthefirm'sequityunderthe
scenariomostsuitedtousingthetwostageFCFEmethod?
A) $129.5million.
B) $173.3million.
C) $125.2million.
Explanation
The"sustainedgrowth"scenarioistheonlyscenariosuitableforusingthetwostagemethod,inpartbecausethe"high
growth"scenariousesthreedifferentrequiredratesofreturn.
First,weneedtocalculateestimatedFCFEin2006.SincetherewerenosalesofPPE,wecancalculateFCInvasthechange
inGrossPPE.
FCFE=NI+NCCFCInvWCInv+NetBorrowing
=16.9+80(480400)[(5570)(5050)]+(113.1140)
=16.9+8080+1526.9
=$5millionin2006
HavingcalculatedFCFEin2006,wecancalculateFCFEfor2007through2011usingthegrowthratesprovided:
2007
GrowthinFCFE
2008
2009 2010
2011
8.3%
Impliedlevelof
FCFE
$7.0
$8.1
$8.8
$9.6
$10.4
(inmillions)
NowthatweknowFCFE,wecandiscountfutureFCFEbacktothepresentatthecostofequity.
Inthefirststageofthetwostagemodel,wedeterminetheterminalvalueatthestartoftheconstantgrowthperiodasfollows:
TerminalValue=(10.41.06)/(0.120.06)=$183.733million.
Inthesecondstage,wediscountFCFEforthefirstsixyearsandtheterminalvaluetothepresent.
EquityValue=[5.0/(1.12)1]+[7.0/(1.12)2]+[8.1/(1.12)3]+[8.8/(1.12)4]+[9.6/(1.12)5]+[(10.4+183.7333)/(1.12)6]
EquityValue=4.46+5.58+5.77+5.59+5.45+98.35
EquityValue=$125.20million
(StudySession12,LOS36.j)
Question#30of145
QuestionID:463303
WhatistheexpectedgrowthrateinFCFFthatCarsonmusthaveusedtogeneratehisvaluationof$1.08billion?
A) 5%.
B) 7%.
C) 12%.
Explanation
SinceFirmValue=FCFF 1/(WACCg),wefirstneedtodetermineFCFF 1,whichisFCFFin2006:FCFF=NI+NCC+[Int
(1taxrate)]FCInvWCInv
=16.9+80+[34(10.35)](480400)[(5570)(5050)]
=16.9+80+22.180(15)=54
FirmValue=FCFF 1/(WACCg)
1080=54/(0.12x)
[(1080)(0.12)]1080x=54
129.61080x=54
75.6=1080x
0.07=x
TheexpectedgrowthrateinFCFFthatCarsonmusthaveusedis7%.(StudySession12,LOS36.j)
Question#31of145
QuestionID:463304
IfCarsonhadestimatedFCFEundertheassumptionthatOverhaulTruckingmaintainsatargetdebttoassetratioof36
percentfornewinvestmentsinfixedandworkingcapital,whatwouldbehisforecastof2006FCFE?
A) $9.6million.
B) $26.5million.
C) $16.9million.
Explanation
FCFE=NI[(1DR)(FCInvDep)][(1DR)WCInv]
Where:DR=targetdebttoassetratio
FCFE=16.9[(10.36)(48040080)][(10.36)((5570)(5050))]
=16.9(0.640)(0.64(15))
=16.9+0+9.6=26.5
(StudySession12,LOS36.j)
Question#32of145
QuestionID:463305
RegardingthestatementsmadebyCarsonandEckhardtaboutthevalueofOverhaulinthehighgrowthscenario:
A) botharecorrect.
B) onlyoneiscorrect.
C) bothareincorrect.
Explanation
Thisisacomplexproblem.Itwouldhelptocreateatable:
2006
2007
(year1) (year2)
2008
2009
(year3) (year4)
2010
(year5)
2011
(year6)
2012
(year7)
GrowthinFCFE(given)
ForecastFCFE(calculated)
Requiredreturntoequity
(given)
Totaldiscountfactor
(calculated)
n/a
5.0
30%
6.50
30%
8.45
30%
10.99
21%
13.29
12%
14.89
3%
15.33
20%
20%
20%
20%
15%
15%
15%
1.20
(1.20)2
(1.20)3
(1.20)4
(1.20)4(1.15)
(1.20)4(1.15)2
(1.20)4(1.15)3
PVofFCFE
4.17
4.51
4.89
5.30
5.57
5.43
4.86
WebeginwiththeforecastgrowthratesinFCFEinline1.SincewehavepreviouslycalculatedthatFCFEis$5millionin2006,
wecanusethegrowthratesfromline1toforecastFCFEineachyearonline2.
Line3,requiredreturntoequity,isgiven.Usingthat,wecancalculatediscountfactorsinline4.
Noticethatthetotaldiscountfactorissimplyeachyear'sfactormultipliedtogether.Forexample,thetotaldiscountfactorfor
year4is(1.20)4sothetotaldiscountfactorforyear5,whentheyear5requiredrateofreturndropsfrom20%to15%,
becomes(1.20)4(1.15).
Usingthetotaldiscountfactorsfromline4,wecancalculatethepresentvalueofeachyear'scashflowinline5.Forexample,
thepresentvalueofyear2010FCFEof$13.29millionwillbe$13.29/[(1.20)4(1.15)]or$5.57million.
Oncewehavethediscountedcashflowsforeachyear,weneedtocalculatetheterminalvalue.Terminalvaluewillbe:
TV=(15.33)(1.03)/(0.100.03)
TV=15.7899/0.07
TV=$225.57million
Notethattherequiredrateofreturnusedfortheterminalvalueistherateforthesteadygrowthperiod,whichislowerthan
thatusedinthehighgrowthphase(stage)orthedeclininggrowthphase(stagetwo).
Wenowneedtodiscountterminalvaluebackusingthetotaldiscountfactorfor2012:
PVofterminalvalue=$225.57million/[(1.20)4(1.15)3]
PVofterminalvalue=$71.53million
Addingtogetherthediscountedcashflowsforeachyearwiththediscountedterminalvalue,wehave:
Equityvalue=4.17+4.51+4.89+5.30+5.57+5.43+4.86+71.53=$106.26million
Sincetheequityvalueofthefirmis$106.26million,Burcarshouldbewillingtopayupto$106.260.15=$15.94millionfora
15%stakeinthefirm.Sincethisisslightlylessthan$16million,Carson'sstatementiscorrect.Theterminalvaluerepresents
($71.53/$106.26)=67.3%ofthefirm'spresentvalue,soEckhardt'sstatementisalsocorrect.(StudySession12,LOS36.j)
Question#33of145
QuestionID:463190
Incomputingfreecashflow,themostsignificantnoncashexpenseisusually:
A) depreciation.
B) capitalexpenditures.
C) deferredtaxes.
Explanation
Depreciationisusuallythelargestnoncashexpense.
Question#34of145
Afirmhas:
Freecashflowtothefirm=$4.0million.
Weightedaveragecostofcapital=10%.
Totaldebt=$30.0million.
Longtermexpectedgrowthrate=5%.
Valueofthefirm=$50.00pershare.
Whatwillhappentothevalueofthefirmiftheweightedaveragecostofcapitalincreasesto12%?
A) Thevaluewillremainthesame.
B) Thevaluewillincrease.
QuestionID:463307
C) Thevaluewilldecrease.
Explanation
Everythingelsebeingconstant,anincreaseintherelevantrequiredrateofreturnshoulddecreasethevalueofthefirm.
Question#35of145
QuestionID:463310
Infiveyears,afirmisexpectedtobeoperatinginastageofitslifecyclewhereinitsexpectedgrowthrateis5%,indefinitelyitsrequired
rateofreturnonequityis11%itsweightedaveragecostofcapitalis9%andthefreecashflowtoequityinyear6willbe$5.25per
share.Whatisitsprojectedterminalvalueattheendofyear5?
A) $131.25.
B) $51.93.
C) $87.50.
Explanation
Terminalvalue=FCFE/(kg)=$5.25/(0.110.05)=$87.50
Question#36of145
QuestionID:463202
Inforecastingfreecashflowsitiscommontoassumethatinvestmentinworkingcapital:
A) isgreaterthanfixedcapitalinvestmentduringagrowthphase.
B) willbefinancedusingthetargetdebtratio.
C) willequalfixedcapitalinvestment.
Explanation
Itisusuallyassumedthattheinvestmentinworkingcapitalwillbefinancedconsistentwiththetargetdebtratio.
Question#37of145
QuestionID:463311
Terminalvalueinmultistagefreecashflowvaluationmodelsisoftencalculatedasthepresentvalueof:
A) atwostagevaluationmodel'sprice.
B) freecashflowdividedbythegrowthrate.
C) aconstantgrowthmodel'spriceasofthebeginningofthelaststage.
Explanation
Terminalvaluesareusuallycalculatedasthepresentvalueofthepriceproducedbyaconstantgrowthmodelasofthebeginningofthe
laststage.
Questions#3843of145
ThefollowinginformationwascollectedfromthefinancialstatementsofBankersIndustrialCorp(BIC)fortheyearendedDecember31,
2013.
Earningsbeforeinterestandtaxes(EBIT)=$6.00million.
Capitalexpenditures=$1.25million.
Depreciationexpense=$0.63million.
Workingcapitaladditions=$0.59million.
Costofdebt=10.50%.
Costofequity=16.00%.
StablegrowthrateforFCFF=7.00%.
StablegrowthrateforFCFE=10.00%.
Marketvalueofdebt=$20.00million.
Bookvalueofdebt=$22.50million.
Outstandingshares=500,000.
Interestexpense=$2.00million.
NewDebtborrowing=$3.30million.
Debtrepayment=$2.85million.
GrowthratesfortwostagegrowthmodelforFCFE:
25.0%forYears13.
6.0%forYears4andthereafter.
BICiscurrentlyoperatingattheirtargetdebtratioof40.00%.Thefirm'staxrateis40.00%.
Question#38of145
QuestionID:463260
Thefreecashflowtothefirm(FCFF)forthecurrentyearisclosestto:
A) $3.57million.
B) $2.39million.
C) $2.31million.
Explanation
TheFCFFforthecurrentyearis[$6.00m(10.40)]+$0.63m$1.25m$0.59m=$2.39m.
(LOS36.d)
Question#39of145
TheappropriatediscountratetoapplyinvaluingBICusingFCFFisclosestto:
QuestionID:463261
A) 12.1%.
B) 16.0%.
C) 13.8%.
Explanation
Theappropriatediscountratetouseistheweightedaveragecostofcapital(WACC),andthisisWACC=(0.600.16)+[0.400.105
(10.40)]=12.12%.
(LOS36.j)
Question#40of145
QuestionID:463262
Theestimatedvalueofthefirmisclosestto:
A) $38million.
B) $47million.
C) $50million.
Explanation
ThevalueofBICusingastablegrowthFCFFmodelis$49.95million,calculatedas:
FCFF=[$6.00m(10.40)]+$0.63m$1.25m$0.59m.=$2.39m
WACC=(0.600.16)+[0.400.105(10.40)]=12.12%.
Estimatedvalue=($2.39m1.07)/(0.12120.07)=$49.95million.
(LOS36.j)
Question#41of145
QuestionID:463263
Iftheestimatedvalueofthefirmis$50.0million,thevaluepershareofBICstockshouldbeclosestto:
A) $60.
B) $28.
C) $30.
Explanation
Equityvalue=Firmvaluemarketvalueofdebt$50million$20million=$30million:
$30,000,000/500,000=$60.00pershare.
(LOS36.j)
Question#42of145
QuestionID:463264
Iftheestimatedvalueofthefreecashtothefirm(FCFF)foryear0is$2.4million,thevaluepershareofBICstock,basedon
thestablegrowthmodel,isclosestto:
A) $61
B) $55
C) $39
Explanation
FCFE=FCFFInterestexpense(1taxrate)+Netborrowing=$2.40million[$2.00million(10.40)]+$3.30million
$2.85million=$1.65million.
Thevalueofequityis:[$1.65million(1+0.10)]/(0.160.10)=$30.25million.
Onapersharebasis:$30.25million/500,000=$60.50
(LOS36.j)
Question#43of145
QuestionID:463265
ThecurrentmarketpriceofBICis$62.50pershare,andthecurrentyear'sFCFEis$1.75million.Usingatwostagegrowth
modeltofindtheestimatedthefirm'svalue,thecurrentmarketpriceBICismostaccuratelydescribedas:
A) overvalued.
B) fairlyvalued.
C) undervalued.
Explanation
FCFE=FCFFInterestexpense(1T)+Newborrowing.
Year
Growthrate
FCFEin
mil$
Theterminalvalueis$3,623/(0.160.06)=$36,230million.Thecalculatorinputs:CF0=0,CF1=$2,188,CF2=$2,734,CF3
=$3,418+$36,230=$39,648,I=16,NPV=$29.319million.
Persharepriceis$29,319,000/500,000=$58.64.Thestockappearstobeovervaluedatthecurrentmarketpriceof$62.50
pershare,asourestimatedvalueof$58.64suggeststhatthemarketpriceistoohigh.
(LOS36.m)
Question#44of145
Thedifferencebetweenfreecashflowtoequity(FCFE)andfreecashflowtothefirm(FCFF)is:
A) beforetaxinterestandnetborrowing.
B) earningsbeforeinterestandtaxes(EBIT)lesstaxes.
C) aftertaxinterestandnetborrowing.
Explanation
QuestionID:463174
FCFE=FCFF[interestexpense](1taxrate)+netborrowing.
Question#45of145
QuestionID:463222
Therepurchaseof20%ofafirm'soutstandingcommonshareswillcausefreecashflowtothefirm(FCFF)to:
A) decrease.
B) remainthesame.
C) increase.
Explanation
Sharerepurchasesareauseoffreecashflows,notasource.FCFFiscashflowthatisavailabletoallcapitalsuppliers.Noticethe
conspicuousabsenceofrepurchasesinthefollowing:FCFF=CFO+Int(1taxrate)FCInv.
Question#46of145
QuestionID:463230
Whichofthefollowingfreecashflowtothefirm(FCFF)modelsismostsuitedtoanalyzefirmsthataregrowingatafasterratethanthe
overalleconomy?
A) HighgrowthFCFFmodel.
B) NogrowthFCFFmodel.
C) TwostageFCFFmodel.
Explanation
ThetwostageFCFFmodelismostsuitedforanalyzingfirmsgrowingataratefasterthantheoveralleconomy.Thetwostagemodel
assumesahighrateofgrowthforaninitialperiod,followedbyanimmediatejumptoaconstant,stablegrowthrate.
Question#47of145
QuestionID:463258
ThevalueofstockunderthetwostageFCFEmodelwillbeequalto:
A) presentvalue(PV)ofFCFEduringtheextraordinarygrowthandtransitional
periodsplusthePVofterminalvalue.
B) presentvalue(PV)ofFCFEduringtheextraordinarygrowthperiodplustheterminal
value.
C) presentvalue(PV)ofFCFEduringtheextraordinarygrowthperiodplusthePVof
terminalvalue.
Explanation
ThevalueofstockunderthetwostageFCFEmodelwillbeequaltothepresentvalueofFCFEduringtheextraordinary
growthperiodplusthepresentvalueoftheterminalvalueattheendofthisperiod.
Question#48of145
QuestionID:463308
Afirmhas:
Freecashflowtoequity=$4.0million.
Costofequity=12%.
Longtermexpectedgrowthrate=5%.
Valueofequitypershare=$57.14pershare.
Whatwillhappentothevalueofthefirmiffreecashflowtoequitydecreasesto$3.2million?
A) Thereisinsufficientinformationtotell.
B) Thevaluewilldecrease.
C) Thevaluewillincrease.
Explanation
Everythingelsebeingconstant,adecreaseinfreecashflowtoequityshoulddecreasethevalueofthefirm.
Question#49of145
QuestionID:463236
Whichofthefollowingfreecashflowtoequity(FCFE)modelsismostsuitedtoanalyzefirmsinanindustrywithsignificantbarriersto
entry?
A) StableGrowthFCFEModel.
B) TwostageFCFEModel.
C) FCFEPerpetuityModel.
Explanation
ThetwostageFCFEmodelismostsuitedforanalyzingfirmsinhighgrowththatwillmaintainthatgrowthforaspecificperiod,suchas
firmswithpatentsorfirmsinanindustrywithsignificantbarrierstoentry.
Question#50of145
QuestionID:463193
WhichofthefollowingitemsisNOTsubtractedfromthenetincometocalculatefreecashflowtoequity(FCFE)?
A) increaseinaccountsreceivable.
B) Interestpaymentstobondholders.
C) Increaseinfixedassets.
Explanation
Interestpaymentstobondholdersareincludedintheincomestatementandarealreadysubtractedtocalculatenetincome.
Question#51of145
QuestionID:463200
Onapersharebasisforafirm:
Salesare$10.00.
Earningspershare(EPS)is$4.00.
Depreciationis$3.00.
Aftertaxinterestis$2.40.
Investmentinworkingcapitalis$1.50.
Investmentinfixedcapitalis$2.00.
Whatisthefirm'sexpectedfreecashflowtothefirm(FCFF)pershare?
A) $5.90.
B) $7.50.
C) $2.90.
Explanation
FCFF=EPS+netnoncashcharges+aftertaxinterestFCInvWCInv
FCFF=$4.00+3.00+$2.40$2.001.50=$5.90
Question#52of145
QuestionID:463277
Afirm'sfreecashflowtoequity(FCFE)inthemostrecentyearis$50Mandisexpectedtogrowat5%peryearforever.Ifits
shareholdersrequireareturnof12%,thevalueofthefirm'sequityusingthesinglestageFCFEmodelis:
A) $714M.
B) $417M.
C) $750M.
Explanation
Thevalueofthefirm'sequityis:$50M1.05/(0.120.05)=$750M
Question#53of145
QuestionID:463309
InthetwostageFCFEmodel,therequiredrateofreturnforcalculatingterminalvalueshouldbe:
A) lowerthantherequiredrateofreturnusedforthehighgrowthphase.
B) higherthantherequiredrateofreturnusedforthehighgrowthphase.
C) equaltotheaveragerequiredrateofreturnfortheindustry.
Explanation
Inmostcases,therequiredrateofreturnusedtocalculatetheterminalvalueshouldbelowerthantherequiredrateofreturn
usedforinitialhighgrowthphase.Duringthestableperiodthefirmislessriskyandtherequiredrateofreturnistherefore
lower.
Questions#5459of145
BeachwoodBuildersmergedwithCountryPointHomesinDecember31,1992.Bothcompanieswerebuildersofmidscale
andluxuryhomesintheirrespectivemarkets.In2004,becauseoftaxconsiderationsandtheneedtosegmentthebusinesses
betweenmidscaleandluxuryhomes,BeachwooddecidedtospinoffCountryPoint,itsluxuryhomesubsidiary,toitscommon
shareholders.BeachwoodretainedBernheimSecuritiestovaluethespinoffofCountryPointasofDecember31,2004.
Whenthebooksclosedon2004,Beachwoodhad$140millionindebtoutstandingduein2012atacouponrateof8%,a
spreadof2%abovethecurrentriskfreerate.Beachwoodalsohad5millioncommonsharesoutstanding.Itpaysno
dividends,hasnopreferredshareholders,andfacesataxrateof30%.Whenvaluingcommonstock,Bernhiem'svaluation
modelsutilizeamarketriskpremiumof11%.
ThecommonequityallocatedtoCountryPointforthespinoffwas$55.6millionasofDecember31,2004.Therewasnolong
termdebtallocatedfromBeachwood.
TheManagingDirectorinchargeofBernheim'sconstructiongroup,DenzelJohnson,ispreppingforthevaluationpresentation
forBeachwood'sboardwithCaraNguyen,oneofthefirm'sassociates.NguyentellsJohnsonthatBernheimestimated
CountryPoint'snetincomeat$10millionin2004,growing$5millionperyearthrough2008.BasedonNguyen'scalculations,
CountryPointwillbeworth$223.7millionin2008.NguyendecidedtouseacostofequityforCountryPointinthevaluation
equaltoitsreturnonequityattheendof2004(roundedtothenearestpercentagepoint).
NguyenalsogivesJohnsonthetablesheobtainedfromBeachwoodprojectingdepreciation(theonlynoncashcharge)and
capitalexpenditures:
$(inmillions)
Depreciation
CapitalExpenditures
10
12
Lookingatthenumbers,JohnsontellsNguyen,"CountryPoint'sfreecashflow(FCF)willbe$25millionin2006."Nguyen
adds,"That'sFCFtotheFirm(FCFF).FCFtoEquity(FCFE)willbelower."
Question#54of145
QuestionID:463286
RegardingthestatementsbyJohnsonandNguyenaboutFCFin2006:
A) onlyNguyenisincorrect.
B) bothareincorrect.
C) onlyJohnsonisincorrect.
Explanation
ToestimateFCF,wecanconstructthefollowingtableusingthetablegivenandtheinformationaboutgrowthinnetincome:
$(inmillions)
NetIncome
10
15
20
25
30
Plus:Depreciation
Less:CapitalExpenditures
10
12
FreeCashFlow
13
16
21
23
Theestimatedfreecashflowfor2006is$16million.Johnson'sstatementisincorrect.SincenoneofBeachwood'sdebtis
allocatedtoCountryPoint,allthefinancingisintheformofequity,soFCFFandFCFEareequal.Nguyen'sstatementisalso
incorrect.(StudySession12,LOS36.j)
Question#55of145
QuestionID:463287
IfFCInvequalsFixedCapitalInvestmentandWCInvequalsWorkingCapitalInvestment,whichstatementaboutFCFandits
componentsisleastaccurate?
A) WCInvisthechangeintheworkingcapitalaccounts,excludingcashand
shorttermborrowings.
B) FCFF=(EBITDA(1taxrate))+(Depreciationtaxrate)FCInvWCInv.
C) FCFE=(EBIT(1taxrate))+DepreciationFCInvWCInv.
Explanation
Thecorrectversionofthisequationis:
FCFF=(EBIT(1taxrate))+DepreciationFCInvWCInv(StudySession12,LOS36.j)
Question#56of145
QuestionID:463288
WhatisthecostofcapitalthatNguyenusedforhervaluationofCountryPoint?
A) 17%.
B) 15%.
C) 18%.
Explanation
SincethereisnodebtallocatedtoCountryPoint,thecostofcapitalwillequalthecostofequity.Nguyensaidthatsheuseda
costofequityequaltoCountryPoint'sReturnonEquity(ROE)atyearend,roundedtothenearestpercentagepoint.Since
thenetincomeattheendof2004was$10millionandtheallocatedcommonequitywas$55.6million,thereturnofequityis
(10million/55.6million)=18%.(StudySession18,LOS62.c)
Question#57of145
QuestionID:463289
GivenNguyen'sestimateofCountryPoint'sterminalvaluein2008,whatisthegrowthassumptionshemusthaveusedforfree
cashflowafter2008?
A) 3%.
B) 7%.
C) 9%.
Explanation
Weknowtheterminalvaluein2008is$223.7million.Wecancalculatethefreecashflowin2008tobe$23million(=$30
millionnetincome+$5milliondepreciation$12millioncapitalexpenditures).(Seethetableinquestion1).Thus,wecan
solvefortheestimatedgrowthrate:
Terminalvalue=[CF@2008(growthrate+1)]/(discountrategrowthrate)
223.7million=($23million(growthrate+1))/(0.18growthrate)
223.7million(0.18growthrate)=23million(growthrate+1)
40.266(223.7growthrate)=23million+(23growthrate)
17.266=246.7(growthrate)
growthrate=0.07
Nguyen'sgrowthrateassumptionis7%peryear.(StudySession12,LOS36.c)
Question#58of145
QuestionID:463290
ThevalueofbetaforCountryPointis:
A) 1.09.
B) 1.00.
C) 1.27.
Explanation
Theriskfreerateis(8%2%)=6%.Wearetoldthatthemarketriskpremiumis11%,andwecalculatedthecostofequity
(requiredreturn)tobe(10million/55.6million=)18%.Sinceweknowtheriskfreerate,themarketriskpremium,andthe
discountrate,wecanusethecapitalassetpricingmodeltosolveforbeta:
Requiredrateofreturn=0.18=0.06+(b0.11)
0.180.06=b0.11
0.12=b0.11
b=1.09
(StudySession12,LOS36.c)
Question#59of145
QuestionID:463291
WhatistheestimatedvalueofCountryPointinaproposedspinoff?
A) $162.6million.
B) $178.3million.
C) $144.5million.
Explanation
Usingthediscountedcashflowapproachonthelevelsofcashflowwecalculated(seethetableinquestion1):
Firmvalue=($13/1.181)+($16/1.182)+($21/1.183)+($23/1.184)+($223.7/1.184)
=$11.0+$11.5+$12.8+$11.9+$115.4
=$162.6million
(StudySession12,LOS36.c)
Question#60of145
QuestionID:463212
Thedifferencebetweenthevalueestimateproducedbythedividenddiscountmodel(DDM)andtheoneproducedbythefreecashflowto
equity(FCFE)modelcanbeaccountedforbywhichofthefollowing?
A) Differentsalesforecast.
B) Thevalueincontrollingthefirm'sdividendpolicy.
C) Differentestimatesofmodelrisk.
Explanation
ThedifferencebetweenthevalueestimateproducedbytheDDMandtheoneproducedbytheFCFEmodelcanbeinterpretedasthe
valueofcontrollingthefirm'sdividendpolicy.
Question#61of145
QuestionID:463256
Afirm'sfreecashflowtothefirm(FCFF)inthemostrecentyearis$80Mandisexpectedtogrowat3%peryearforever.Ifthefirmhas
$100Mindebtfinancinganditsweightedaveragecostofcapitalis10%.Thevalueofthefirm'sequityusingthesinglestageFCFFmodel
is:
A) $1,177M.
B) $1,043M.
C) $1,077M.
Explanation
Thevalueofthefirm'sequityisequaltothevalueofthefirmminusthevalueofthedebt.Firmvalue=$80M1.03/(0.100.03)=
$1,177M,soequityvalueis$1,177M$100M=$1,077M.
Question#62of145
QuestionID:463267
AnanalysthaspreparedthefollowingscenariosforSchneider,Inc.:
Scenario1Assumptions
TaxRateis40%.
Weightedaveragecostofcapital(WACC)=12%.
Constantgrowthrateinfreecashflow=3%.
Lastyear,freecashflowtothefirm(FCFF)=$30.
Targetdebtratio=10%.
Scenario2Assumptions
TaxRateis40%.
Expensesbeforeinterestandtaxes(EBIT),capitalexpenditures,anddepreciationwillgrowat15%forthenextthreeyears.
Afterthreeyears,thegrowthinEBITwillbe2%,andcapitalexpenditureanddepreciationwilloffseteachother.
Weightedaveragecostofcapital(WACC)duringhighgrowthstage=20%.
Weightedaveragecostofcapital(WACC)duringstablegrowthstage=12%.
Targetdebtratio=10%.
Year0
Scenario2FCFF
Year1
Year2
Year3
Year4
$15.00
$17.25
$19.84
$22.81
$23.27
CapitalExpenditures
6.00
6.90
7.94
9.13
Depreciation
4.00
4.60
5.29
6.08
ChangeinWorkingCapital
2.00
2.10
2.20
2.40
2.40
5.95
7.06
8.25
11.56
(lastyear)
EBIT
FCFF
GiventheassumptionscontainedinScenario2,whatisthevalueofthefirm?
A) $81.54.
B) $96.92.
C) $70.39.
Explanation
UsethetwostageFCFFmodeltovaluethefirm.TheTerminalValueofthefirmasofYear3=11.56/(0.120.02)=115.60.Thevalue=
5.95/(1.20)+7.06/(1.20)2+(8.25+115.62)/(1.20)3=81.54.
Question#63of145
QuestionID:463237
WhichofthefollowingstatementsregardingtheFCFFmodelsismostaccurate?ThetwostageFCFFmodelismoreusefulthanthe
stablegrowthFCFFmodelwhenthefirmisgrowingatarate:
A) significantlyhigherthanthatoftheoveralleconomy.
B) notsignificantlyhigherthanthatoftheoveralleconomy.
C) significantlylowerthanthatoftheoveralleconomy.
Explanation
ThetwostageFCFFmodelismoreusefulinvaluingafirmthatisgrowingataratesignificantlyhigherthantheoveralleconomy.Since
thiscannotpersistindefinitely,growthwilleventuallyslowtoastablegrowthrateconsistentwiththatoftheeconomy.
Questions#6469of145
ThefollowinginformationwascollectedfromthefinancialstatementsofHillerGmbH,aGermanconsultingcompany,fortheyearending
December31,2013:
Earningspershare=
4.50.
CapitalExpenditurespershare=
3.00.
Depreciationpershare=
2.75.
Increaseinworkingcapitalpershare=
0.75.
Debtfinancingratio=30.0%.
Costofequity=12.0%.
Costofdebt=6.0%.
Taxrate=30.0%.
Outstandingshares=100million.
Newdebtborrowing=
15.0million.
Debtrepayment=
30.0million.
Interestexpense=
7.1million.
Thefinancialleverageforthefirmisexpectedtobestable.HillerusesIFRSaccountingstandardsandrecordsinterestexpenseascash
flowfromfinancing(CFF).
TwoanalystsarevaluingHillerstockbotharebasingtheiranalysisonFCFEapproaches.
Analyst#1remarks:"Hillerisarelativelymaturecompanyaconstantgrowthmodelisthebetterapproach."
Analyst#1estimatesFCFEbasedontheinformationaboveandagrowthrateof5.0%.
Analyst#2states:"Hillerjustacquiredarivalthatshouldchangetheirgrowthpattern.Ithinkathreestagegrowthmodelbasedon
industrygrowthpatternsshouldbeused."
Analyst#2estimatesFCFEpershareas
3.85.Growthrateestimatesarelistedbelow,andfromyear7andthereaftertheestimated
growthrateis3.0%.
Year1
Year2
Year3
Year4
Year5
Year6
Year7+
Growthrates
12.5%
12.5%
12.5%
8.0%
6.5%
5.0%
3.0%
Question#64of145
QuestionID:463206
TheFCFEbasedonAnalyst#1'sestimatesforthebaseyearisclosestto:
A)
3.80.
B)
3.00.
C)
4.85.
Explanation
BaseyearFCFE=EPS(capitalexpendituresdepreciation)(1debtratio)increaseinworkingcapital(1debtratio)=
4.50
(
3.00
2.75)(10.30)
0.75(10.30)=
3.80.(LOS36.d)
Question#65of145
QuestionID:463207
UsingthestablegrowthFCFEmodelassuggestedbyAnalyst#1,thevalueofHillerstockisclosestto:
A) 51.58.
B) 54.29.
C) 57.00.
Explanation
Valuepershare=(3.801.05)/(0.120.05)=57.00.(LOS36.j)
Question#66of145
QuestionID:463208
BasedonAnalyst#2'sestimates,thesumoftheterminalvalueplustheFCFEforyear6isclosestto:
A)
82.40.
B)
60.70.
C)
75.80.
Explanation
EstimatesforthefutureFCFEbasedonsuppliedgrowthratesare:
Year
Growthrate
12.5%
12.5%
12.5%
8.0%
6.5%
5.0%
3.0%
FCFE/share
3.850
4.331
4.873
5.482
5.893
6.335
6.620
6.818
Terminalvalueyear6=6.818/(12.0%3.0%)=
75.76
Thenominalcashflowforyear6is
75.76+
6.62=
82.38,whichistheterminalcashflowplustheFCFEvaluefortheyear.(LOS36.e)
Question#67of145
QuestionID:463209
BasedonAnalyst#2'sestimates,thevalueofHillerstockisclosestto:
A)
59.70.
B)
57.00.
C)
60.70.
Explanation
Year
Growthrate
FCFE/share
3.850
12.5%
12.5%
12.5%
8.0%
6.5%
5.0%
3.0%
4.331
4.873
5.482
5.893
6.335
6.620
6.818
Terminalvalueyear6=6.818/(12.0%3.0%)=
75.76
ForthecalculatorfindNPV:CF0=0,CF1=
4.33,CF2=
4.87,CF3=
5.48,CF4=
5.89,CF5=
6.34,CF6=
82.38,I/Y=12.Theresultis
60.73.(LOS36.e)
Question#68of145
QuestionID:463210
TheappropriatediscountrateforvaluingHilleronafreecashflowbasisisclosestto:
A) 12.00%.
B) 6.54%.
C) 9.66%.
Explanation
Theappropriatediscountrateistheweightedaveragecostofcapital.Theformulais:WACC=wdrd(1taxrate)+were=(0.30)
(0.06)(10.30)+(0.70)(0.12)=0.0966or9.66%.(LOS36.j)
Question#69of145
QuestionID:463211
IfHiller'stotalfreecashflowtoequityis
380millionandthegrowthrateofthefirmis3.5%,thevalueofHiller(Firm)usingthestable
growthmodelisclosestto:
A)
6.7billion.
B)
8.9billion.
C)
4.8billion.
Explanation
FCFF=FCFENetborrowing+interestexpense(1taxrate).
FCFF=
380million+(7.1million(10.3))(
15million)=
399.7million.
Theweightedaveragecostofcapitalis:(0.30)(0.06)(10.30)+(0.70)(0.12)=0.0966or9.66%.
Thevalueofthefirmisthen:[
399.7million(1+0.035)]/(0.09660.035)=
6,720million.(LOS36.d)
Question#70of145
QuestionID:463266
Usingthestablegrowthfreecashflowtothefirm(FCFF)model,whatisthevalueofQualityBuildersundertheassumptionscontainedin
thetablebelow?
QualityBuilders
FreeCashFlowtotheFirm
Year0
EBIT
$500
Depreciation
$200
CapitalSpending
$300
WorkingCapitalAdditions
TaxRate
AssumedConstantGrowthRatein
FreeCashFlow
WeightedaverageCostofCapital
$30
40%
5%
11%
A) $2,975.00.
B) $2,833.33.
C) $6,475.00.
Explanation
ThestablegrowthFCFFmodelassumesthatFCFFgrowsataconstantrateforever.FCFFinYear0isequaltoEBIT(1taxrate)+
DepreciationCapitalSpendingWorkingCapitalAdditions=500(10.4)+20030030=170.TheFirmValue=FCFF1/(rgn)=
170(1.05)/(0.110.05)=$2,975.
Question#71of145
QuestionID:463257
IndustrialLightcurrentlyhas:
Freecashflowtoequity=$4.0million.
Costofequity=12%.
Weightedaveragecostofcapital=10%.
Totaldebt=$30.0million.
Longtermexpectedgrowthrate=5%.
Whatisthevalueofequity?
A) $57,142,857.
B) $60,000,000.
C) $27,142,857.
Explanation
Thevalueofequityis[($4,000,000)(1.05)/(0.120.05)]=$60,000,000.
Question#72of145
QuestionID:463173
WhenusingthetwostageFCFEmodel,ifincreasesinworkingcapitalappeartoohightheanalystshould:
A) switchtoathreestagemodel.
B) normalizethemtobeequaltozero.
C) usechangesthatarebaseduponaworkingcapitalratiothatisclosertotheindustryaverage.
Explanation
Thebestsolutionistousechangesthatarebaseduponaworkingcapitalratiothatapproximatestheindustryaverage.Theproblemwill
notbeeliminatedbyswitchingtoathreestageFCFEmodel.
Question#73of145
QuestionID:463204
Acommonapproachtoforecastingfreecashflowsisto:
A) calculatehistoricalfreecashflowandapplyanexpectedgrowthrate.
B) projectearningsbeforeinterestandtaxes(EBIT)andexpectedcapitalexpenditures.
C) projectnetincomeandexpectedcapitalexpenditures.
Explanation
Historicalfreecashflowsareoftenusedforforecasting.
Questions#7479of145
StarshahIndustriescompetesinahighgrowth,emergingtechnologysectorthatisfacingincreasingcompetitivepressures.Sofar,the
firmhasbeenperformingwell,earning$4.55persharein2004.Investmentrequirementswerehigh,withcapitalexpendituresof$1.75per
share,depreciationexpenseof$1.05,andanetinvestmentinworkingcapitalthatyearof$1.00pershare.However,despiteStarshah's
highgrowthrateandimpressiveprofitability,Starshah'sChairman,LorenzodiStefano,hasbecomeconcernedabouttheimpactthata
slowdowninexpectedgrowthmayhaveonthefirm'svaluation.
DiStefanoaskedStarshah'sDirectorofStrategicPlanning,KeishaSimmons,tomakeapresentationtoStarshah'sboardattheendof
2004aboutthefuturegrowthofthefirm.Thenewswassobering.SimmonstoldtheboardmembersthatStarshahcouldexpecttwomore
yearsofrapidgrowth,duringwhichtimeearningspersharecouldbeexpectedtorise45%peryearwith30%annualincreasesincapital
spendinganddepreciation.Duringthishighgrowthperiod,SimmonsestimatesthattherequiredreturnonequityforStarshahwillbe25%.
Starshahconsistentlymaintainsatargetdebtratioof0.25.
Aftertheneartermspurtofhighgrowth,however,sheandhergroupexpectStarshahtomoveeventuallytoastablegrowthperiod.During
thestablegrowthperiod,freecashflowtoequity(FCFE)willriseonly5%peryearandtheannualreturntoshareholderswilldeclineto
10%.
Thestrategygroupexpectsthetransitionalperiodbetweenhighgrowthandmaturegrowthtolastfiveyears.Duringthattime,capital
expenditureswillriseonly8%peryear,withdepreciationrising13%peryear.Thegrowthinearningsshoulddropbyeightpercentage
pointsperyear,hitting5%inthefifthyear.Duringthistransition,theexpectedreturntoshareholderswillbe15%peryear.
Throughoutthehighgrowthandtransitionalgrowthperiods,SimmonsexpectsStarshahtobeabletolimitincreasesintheinvestmentin
workingcapitalto20centsperyear.Inheranalysis,theinvestmentinworkingcapitalwillpeakin2010,decliningadimeto$2.10per
sharein2011.
AfterSimmons'presentation,theboarddebatedwhattodoabouttheincipientslowdowninStarshah'sgrowth.Amajorityoftheboard
arguedinfavorofmovingtooffsetthisslowdowninorganicgrowththroughanewemphasisongrowthbyacquisition.
OnepotentialtargetisTPX.TPX'scurrentandexpectedFCFE:$425,000in2004,$500,000in2005,$600,000thefollowingyear,and
$700,000in2007.Afterthat,StarshahexpectsFCFEatTPXtogrow3%peryearindefinitely.Starshahwouldrequireareturnonits
equityinvestmentof20%peryearinthehighgrowthstageand12%peryearinthestablegrowthstage.
DiStefanoandSimmonshadasombermeetingthedayaftertheboardpresentation.Butdespitethebleaknewsaboutfutureyears,di
Stefanohadconvincedhimselfitwasworthstayingaroundthroughthehighgrowthandtransitionalperiods.HepointedouttoSimmons
that,ifSimmons'projectionswerecorrect,thevalueofStarshah'sstockwouldbeinexcessof$450persharebythetimethecompany
hitthestablegrowthphase.DiStefanowasverypleasedwithwhatthatimpliedforthevalueofhisstockoptions.
Simmonshaddonethesamecalculationsherself,butshealsorealizedthatifrequiredratesofreturnin2012rosefromtheverymodest
10%sheusedinherboardprojectionstoonly15%,thatwouldcuttheterminalvalueofStarshah'sstockin2011toonlyhalftheleveldi
Stefanowascountingon.Sheconsideredthatvaluationtoosmalltomakethewaitworthwhile.SimmonssaidnothingtodiStefano,but
plannedtolookforanotherjob.
Question#74of145
QuestionID:463269
WhichofthefollowingFCFEmodelsisbestsuitedtoanalyzingTPX?
A) TwostageFCFEmodel.
B) StablegrowthFCFEmodel.
C) ThreestageFCFEmodel.
Explanation
ThetwostageFCFEmodelismostsuitedtoanalyzingTPXbecausewehavespecificforecastsforthefirstseveralyearsandthena
stablegrowthpatternintotheindefinitefuture.(StudySession12,LOS36.i)
Question#75of145
QuestionID:463270
TheFCFEforStarshahattheendofthetransitionperiodin2011isclosestto:
A) $21.89.
B) $20.62.
C) $23.42.
Explanation
InordertocalculateFCFEforStarshahin2011,weneedtoconstructatableofthecomponentsofcashflowforStarshah.
Wearegiventhe2004valuesfornetincome,capitalexpenditures,depreciation,andchangeinworkingcapital.Wearealsogivengrowth
ratesforeachofthethreestagesofStarshah'sgrowth:highgrowthfortwoyearsfollowedbytransitionalgrowthforfiveyears,culminating
instablegrowthforthefollowingyears.Usingtheoriginalvaluesandtheirrelatedgrowthrates,plustheformulaforFCFE(seebelow),we
canconstructthefollowingtable:
2004
2005
2006
2007
2008
2009
2010
2011
EPS
4.55
6.60
9.57
13.11
16.91
20.46
23.12
24.27
Capitalexpenditures
1.75
2.28
2.96
3.19
3.45
3.73
4.02
4.35
Depreciation
1.05
1.37
1.77
2.01
2.27
2.56
2.89
3.27
Changeinworkingcapital
1.00
1.20
1.40
1.60
1.80
2.00
2.20
2.10
FCFE
3.28
5.02
7.63
11.01
14.67
18.08
20.62
21.89
FCFE=Earningspershare(CapitalExpendituresDepreciation)(1DebtRatio)(Changeinworkingcapital(1DebtRatio))=
24.27(4.353.27)(10.25)(2.10(10.25))
=24.270.811.57=21.89
FCFE=$21.89persharein2011.
(StudySession12,LOS36.j)
Question#76of145
QuestionID:463271
RegardingdiStefano'sandSimmons'statementsabouttheterminalvalueofStarshahstockin2011:
A) botharecorrect.
B) onlySimmonsiscorrect.
C) onlydiStefanoiscorrect.
Explanation
Starshahhitsthestablegrowthphasein2012.Atthatpoint,
TerminalFirmValue2011=(FCFEinyear2012)/(requiredrateofreturn&8722growthrate)
=$21.89(1.05)/(0.100.05)=$22.98pershare/0.05
=$460pershare.DiStefano'sstatementiscorrect.
TerminalFirmValue2011=(FCFEinyear2012)/(requiredrateofreturn&8722growthrate)=$21.89(1.05)/(0.150.05)
=$22.98pershare/0.10=$230pershare.Simmons'statementisalsocorrect.
(StudySession12,LOS36.j)
Question#77of145
QuestionID:463272
AssumingSimmonsisrightthattherequiredreturnonStarshahequityrisesto15%in2012andbeyond,whatisthevalueofStarshah
stockattheendof2004?
A) $63.71.
B) $117.49.
C) $111.35.
Explanation
Inordertocalculatethefirmvalue,weneedtoknowthediscountratethatappliesovereachperiod.Sincethediscountratechanges,we
cansimplifythearithmeticbyconstructingatableofdiscountfactorsusing25%foreachofthefirsttwoyearsand15%foreachofthe
followingfiveyears:
Discountfactor
2005
2006
2007
2008
2009
2010
2011
1.25
1.56
1.80
2.07
2.38
2.73
3.14
Wecanthencalculatefirmvaluein2004usingtheFCFEvalueswecalculatedinquestion1andthestockvalueintheyear2012(thatwe
calculatedinquestion3).
Starshahequityvaluein2004=(5.02/1.25)+(7.63/1.56)+(11.01/1.80)+(14.67/2.07)+(18.08/2.38)+(20.62/2.73)+(21.89/
3.14)+(230/3.14)
=4.02+4.89+6.12+7.09+7.60+7.55+6.97+73.25
=117.49
ThevalueofStarshahstockattheendof2004is$117.49pershare.(StudySession12,LOS36.j)
Question#78of145
QuestionID:463273
WhatisthemaximumamountthatStarshahwouldbewillingtopayforTPX(inmillions)?
A) $5.102.
B) $5.874.
C) $6.941.
Explanation
FirmValue=[500/(1.20)1]+[600/(1.20)2]+[700/(1.20)3]+[(700)(1.03)/(0.12&87220.03)/(1.20)3]=$5,874.
ThemostthatStarshahcouldpayforTPXandstillmeetitsrequiredreturntargetsis$5.874million.(StudySession12,LOS39.j)
Question#79of145
QuestionID:463274
WhichofthefollowingFCFEmodelsisbestsuitedtoanalyzingStarshahIndustries?
A) ThreestageFCFEmodel.
B) TwostageFCFEmodel.
C) StablegrowthFCFEmodel.
Explanation
ThethreestageFCFEmodelismostsuitedtoanalyzefirmsinhighgrowthindustriesthatwillfaceincreasingcompetitivepressuresover
time,sincethosecompetitivepressureswillleadtoagradualdeclineinthefirm'sgrowthrate(secondstage)toastablelevel(third
stage).(StudySession12,LOS36.i)
Question#80of145
QuestionID:463219
Currently,afirmhasnooutstandingdebt.Ifthefirmwouldaddasmallamountofleveragetoitsbalancesheet,whatshouldbethe
impactonthefirm'svalue?Therewouldbe:
A) nochangeinfirmvalue.
B) adecreaseinvalueduetohigherinterestexpense.
C) anincreaseinvalueduetointeresttaxshields.
Explanation
Theamountoffinancialleverageusedbyafirmwillaffectitsvalue.Forsmallamountsofleverage,theadditionalbankruptcyriskwillbe
low,andwillbemorethanoffsetbytheadditionalvalueofinteresttaxshields.
Question#81of145
QuestionID:463201
Inforecastingfreecashflowsitiscommontoassumethat:
A) thefirmhasnononcashexpenses.
B) historicalandfuturefreecashflowwillbethesame.
C) thefirmadherestoatargetcapitalstructure.
Explanation
Atargetdebtratioisusuallyassumedtoremainconstant.Historicalcashflowsareoftenprojectedforwardwithagrowthrate.
Question#82of145
QuestionID:463312
Terminalvalueinamultistagefreecashflowtoequity(FCFE)valuationmodelisoftencalculatedasthepresentvalueof:
A) FCFEdividedbythetotalofrequiredrateonequityminusgrowth.
B) freecashflowdividedbythegrowthrate.
C) atwostagevaluationmodel'sprice.
Explanation
Terminalvaluesareusuallycalculatedasthepresentvalueofthepriceproducedbyaconstantgrowthmodelasofthebeginningofthe
laststage,whichisFCFE/(requiredrateonequitygrowth).
Question#83of145
QuestionID:463231
Whichofthefollowingtypesofcompaniesisthetwostagefreecashflowtoequity(FCFE)modelbestsuitedfor?Companies:
A) inhighgrowthindustriesthatwillfaceincreasingcompetitivepressuresovertime,
leadingtoagradualdeclineingrowthtoastablelevel.
B) growingataratesimilartoorlessthanthenominalgrowthrateoftheeconomy.
C) withpatentsorfirmsinanindustrywithsignificantbarrierstoentry.
Explanation
Thetwostagemodelisbestsuitedtoanalyzingfirmsinahighgrowthphasethatwillmaintainthatgrowthforaspecificperiod,suchas
firmswithpatentsorfirmsinanindustrywithsignificantbarrierstoentry.Companiesgrowingataratesimilartoorlessthanthenominal
growthrateoftheeconomyarebestsuitedforthesinglestageFCFEModel.Companiesinhighgrowthindustriescorrespondtothethree
StageFCFEModel.
Question#84of145
QuestionID:463187
Theownershipperspectiveimplicitinthedividendvaluationapproachisof:
A) apreferredstockholder.
B) acommonstockholder.
C) control.
Explanation
Dividendsaremostrelevanttothestockholderswhoreceivethemandwhohavelittlecontrolovertheiramount.
Question#85of145
QuestionID:463176
WhatisthemostlikelyreasonthatyougetanextremelylowvaluefromthethreestageFCFEmodel?Capitalexpendituresare
significantly:
A) higherthandepreciationduringthehighgrowthphase.
B) higherthandepreciationinthestablegrowthphase.
C) lessthandepreciationduringthehighgrowthphase.
Explanation
Ifcapitalexpendituresestimatesaresignificantlyhigherthandepreciationforthestablegrowthperiod,thenthethreestageFCFEmodel
mightresultinanextremelylowvalue.Onepossiblesolutionfortheproblemistogrowthecapitalexpendituresmoreslowlythan
deprecationinthetransitionperiodtonarrowthedifference.Anotheristoassumethatcapitalexpendituresanddepreciationwilloffset
whengrowthnormalizes.
Question#86of145
Freecashflowtothefirmisequaltocashflowfromoperationsminusfixedcapitalinvestment:
A) minusaftertaxinterestexpense.
B) minuspretaxinterestexpense.
QuestionID:463192
C) plusaftertaxinterestexpense.
Explanation
Freecashflowtothefirmisequaltocashflowfromoperationsminusfixedcapitalinvestmentplusaftertaxinterestexpense.
Question#87of145
QuestionID:463242
WhichofthefollowingtypesofcompanyistheEModel,athreestagefreecashflowtoequity(FCFE)Model,bestsuitedfor?
Companies:
A) growingataratesimilartoorlessthanthenominalgrowthrateoftheeconomy.
B) inhighgrowthindustriesthatwillfaceincreasingcompetitivepressuresovertime,leadingtoa
gradualdeclineingrowthtoastablelevel.
C) withpatentsorfirmsinanindustrywithsignificantbarrierstoentry.
Explanation
ThethreestageFCFEmodel,orEModel,ismostsuitedtoanalyzingfirmscurrentlyexperiencinghighgrowththatwillfaceincreasing
competitivepressuresovertime,leadingtoagradualdeclineingrowthtoastablelevel.Thetwostagemodelisbestsuitedtoanalyzing
firmsinahighgrowthphasethatwillmaintainthatgrowthforaspecificperiod,suchasfirmswithpatentsorfirmsinanindustrywith
significantbarrierstoentry.Companiesgrowingataratesimilartoorlessthanthenominalgrowthrateoftheeconomyarebestsuitedfor
theStableGrowthFCFEModel.Afirmthatpaysoutallofitsearningsasdividendswillhaveagrowthrateofzero(rememberg=RR
ROE)andwouldnotbevaluedusingthethreestageFCFEmodel.
Question#88of145
QuestionID:463167
Freecashflowtothefirmvaluationuseswhichdiscountrate?
A) Aftertaxcostofdebt.
B) Costofequity.
C) Weightedaveragecostofcapital.
Explanation
Freecashflowtothefirmvaluationusestheopportunitycostrelevanttotheoverallfirm,whichistheweightedaveragecostofcapital.
Question#89of145
QuestionID:463203
ThefollowingtableprovidesbackgroundinformationonapersharebasisforTOYInc.intheyear0:
CurrentInformation:
Year0
Earnings
$5.00
CapitalExpenditures
$2.40
Depreciation
$1.80
ChangeinWorkingCapital
$1.70
TOYInc.'stargetdebtratiois30%andhasarequiredrateofreturnof12%.Earnings,capitalexpenditures,depreciation,andworking
capitalareallexpectedtogrowby5%ayearinthefuture.Assumethatcapitalexpendituresandworkingcapitalarefinancedatthetarget
debtratio.
Inyear0,whatisthefreecashflowtoequity(FCFE)forTOYInc.?
A) $4.31.
B) $3.39.
C) $2.70.
Explanation
Year0FCFE=Earningspershare(CapitalExpendituresDepreciation)(1DebtRatio)Changeinworkingcapital(1DebtRatio)=
5.00(2.401.80)(10.3)(1.7)(10.3)=3.39.
Question#90of145
QuestionID:463235
Thestablegrowthfreecashflowtoequity(FCFE)modelisbestsuitedforwhichofthefollowingtypesofcompanies?Companies:
A) growingataratesimilarorlessthanthenominalgrowthrateoftheeconomy.
B) withsignificantbarrierstoentry.
C) withpatentsthatwillnotexpirefor20ormoreyears.
Explanation
CompaniesgrowingataratesimilartoorlessthanthenominalgrowthrateoftheeconomyarebestsuitedfortheStableGrowthFCFE
Model.ThethreestageFCFEmodelismostsuitedtoanalyzingfirmscurrentlyexperiencinghighgrowththatwillfaceincreasing
competitivepressuresovertime,leadingtoagradualdeclineingrowthtoastablelevel.Thetwostagemodelisbestsuitedtoanalyzing
firmsinahighgrowthphasethatwillmaintainthatgrowthforaspecificperiod,suchasfirmswithpatentsorfirmsinanindustrywith
significantbarrierstoentry.
Question#91of145
QuestionID:463218
Optimalcapitalstructureisthemixofdebtandequitythatwillmaximizethevalueofthefirmandminimize:
A) weightedaveragecostofcapital(WACC).
B) weightedaveragecostofequity.
C) interestexpense.
Explanation
TheoptimalcapitalstructureisthemixofdebtandequitythatwillmaximizethevalueofthefirmandminimizetheWACC.
Question#92of145
QuestionID:463166
InthestablegrowthFCFEmodel,anextremelylowvaluecanresultfromallofthefollowingEXCEPT:
A) therequiredrateofreturnistoohighforastablefirm.
B) theexpectedgrowthrateistoohighforastablefirm.
C) capitalexpendituresaretoohighrelativetodepreciation.
Explanation
Iftheexpectedgrowthrateistoohighforastablefirm,thevalueobtainedusingthestablegrowthFCFEmodelwillbeextremelyhigh.
Question#93of145
QuestionID:463195
ThefollowinginformationpertainstotheHarrisburgTireCompany(HTC)in2000.
Earnings(netincome)=$600M.
Dividends=$120M.
Interestexpense=$400M.
Taxrate=40%.
Depreciation=$500M.
Capitalspending=$800M.
Totalassets=$10B(bookvalueandmarketvalue).
Debt=$4B(bookvalueandmarketvalue).
Equity=$6B(bookvalueandmarketvalue).
Thefirm'sworkingcapitalneedsarenegligible,andtheyplantocontinuetooperateattheircurrentcapitalstructure.
Thefreecashflowtothefirmis:
A) $540M.
B) $300M.
C) $420M.
Explanation
Thefreecashflowtothefirmis:
FCFF=Netincome+(Interestexpense)(1T)Capitalexpenditures+Depreciation
600M+400M(10.40)800M+500M=540M
Question#94of145
QuestionID:463168
MarkWashington,CFA,usesatwostagefreecashflowtoequity(FCFE)discountmodeltovalueTexasVanLines.Hisanalysisyields
anextremelylowvalue,whichhebelievesisincorrect.Whichofthefollowingisleastlikelytobeacauseofthissuspectvaluation
estimate?
A) Thecostofequityestimateinthestablegrowthperiodistoohighforastablefirm.
B) Earningsaretemporarilydepressedbecauseofaonetimeextraordinaryaccountingchargein
themostrecentfiscalyear.
C) Theforecastofworkingcapitalasapercentageofrevenuesinthestablegrowthperiodisnot
largeenoughtomaintainthelongtermsustainablegrowthrate.
Explanation
Thelargertheestimateofworkingcapitalasapercentageofrevenues,thelargertheinvestmentinnetworkingcapital,andthelowerthe
FCFEinthestableperiod.AlowstableperiodFCFEestimatewillresultinalowestimateofvaluetoday.Thesolutionistouseaworking
capitalratioclosertothelongrunindustryaverage.
Ifthecostofequityestimateinthestablegrowthperiodistoohigh,theterminalvaluewillbetoolow.Becausetheterminalvalue
typicallymakesupalargeportionofthecurrentvalue,thiswillcausethecurrentvalueestimatetobetoolow.Thesolutionistousea
costofequityestimatebasedonabetaofone.
Ifearningsaretemporarilydepressed,alltheFCFEestimateswillbelow,andthecurrentvalueestimatewillbelow.Thesolutionistouse
anestimateoflongrunnormalizedearnings.
Question#95of145
QuestionID:463194
Afirmcurrentlyhasthefollowingpersharevalues:
Cashflowfromoperations(CFO)is$49.50.
Investmentinfixedcapitalis$40.00.
Netborrowingis$7.50.
Whatisthecurrentpersharefreecashflowtoequity(FCFE)?
A) $97.00.
B) $16.50.
C) $17.00.
Explanation
FCFE=CFOFCInv+netborrowing=$49.50$40.00+$7.50=$17.00
Question#96of145
QuestionID:463213
TheprimarydifferencebetweenthethreestageDDMandtheFCFEmodelis:
A) growthrateassumptions.
B) costofequity.
C) thedefinitionofcashflows.
Explanation
Theprimarydifferencebetweenthedividenddiscountmodelsandthefreecashflowfromequitymodelsliesinthedefinitionofcash
flows.TheFCFEmodelusesresidualcashflowsaftermeetingallfinancialobligationsandinvestmentneeds.TheDDMusesastrict
definitionofcashflowstoequity,thatis,theexpecteddividendsonthestock.
Question#97of145
QuestionID:463171
Freecashflow(FCF)approachesarethebestsourceofvaluewhen:
A) afirmhaspreferredstock.
B) afirmispayingadividendthatishigherthantheindustryaverage.
C) FCFstrackprofitabilitycloselyovertheanalyst'sforecasthorizon.
Explanation
FCFapproachesarebestwhenthoseflowsareagoodindicationofafirm'sprofitabilityovertheanalyst'sforecasthorizon.
Question#98of145
QuestionID:463172
Freecashflowapproachesarethebestsourceofvaluewhen:
A) dividendsarenotpaid.
B) afirmhassignificantminorityinterest.
C) returnonassetsisfalling.
Explanation
Freecashflowapproachesarebestwhendividendsarenotpaid.Bothremainingresponseshavenothingtodowiththedecision.
Question#99of145
QuestionID:463169
IfafirmisvaluedusingFCFF,therelevantdiscountrateisthe:
A) aftertaxweightedaveragecostofcapital.
B) beforetaxweightedaveragecostofcapital.
C) beforetaxcostofequity.
Explanation
SincetheFCFFisthecashavailabletoalltheinvestors,theaftertaxweightedaveragecostofcapitalshouldbeusedasthediscount
rateinFCFFmodels.
Question#100of145
QuestionID:463196
Usingtheinformationbelow,valuethestockofSymphonyPublishing,Inc.usingthefreecashflowfromequity(FCFE)valuationmethod.
Requiredreturnof13.0%.
Valueattheendofyear3of13timesFCFE3.
Sharesoutstanding:10.0million.
Netincomeinyear1of$10.0million,projectedtogrowat10%forthenexttwoyears.
Depreciationperyearof$3.0million.
CapitalExpendituresperyearof$2.5million.
Increaseinworkingcapitalperyearof$1.0million.
Principalrepaymentsondebtperyearof$1.5million.
ThevaluepershareofSymphonyPublishingisapproximately:
A) $11.21.
B) $112.10.
C) $14.10.
Explanation
Step1:Calculateeachyear'sFCFEanddiscountattherequiredreturn.
FCFE=netincome+depreciationcapitalexpendituresincreaseinworkingcapitalprincipalrepayments+newdebtissues
Year1:10.0+3.02.51.01.5=8.0,
PV=7.08=8.0/(1.13)1,orFV=8.0,I=13,PMT=0,N=1,ComputePV
Year2:10.01.10+3.02.51.01.5=9.0,
PV=7.05=9.0/(1.13)2,orFV=9.0,I=13,PMT=0,N=2,ComputePV
Year3:10.0(1.10)2+3.02.51.01.5=10.10
PV=7.00=10.10/(1.13)3,orFV=10.10,I=13,PMT=0,N=3,ComputePV
Step2:CalculatePresentValueoffinalcashflowtimesFCFEmultiple.
Valueatendofyear3=FCFE3multiple=10.1013=131.30
PV=91.00=131.30/(1.13)3,orusingcalculator,N=3,FV=131.30,I=13,PMT=0,ComputePV
Step3:Calculatepersharevalue.
AddupPVofFCFEandendvalueanddividebynumberofsharesoutstanding
=(7.08+7.05+7.00+91.0)/10.0=11.21
Question#101of145
QuestionID:463233
Abiotechfirmiscurrentlyexperiencinghighgrowthandpaysnodividends.Oneoftheirproductpatentsisscheduledtoexpirein5years.
Thisfirmwouldbeagoodcandidateforwhichofthefollowingvaluationmodels?
A) Twostagedividenddiscountmodel(DDM).
B) Twostagefreecashflowtoequity(FCFE).
C) Singlestagefreecashflowtoequity(FCFE).
Explanation
ThetwostageFCFEmodeliswellsuitedtovalueafirmthatiscurrentlyexperiencinghighgrowthandwilllikelyseethisgrowthdroptoa
lower,morestablerateinthefuture.
Question#102of145
QuestionID:463254
BOX,Inc.,earned$4.55persharelastyear.Thefirmhadcapitalexpendituresof$1.75pershareanddepreciationexpenseof$1.05.
BOX,Inc.,hasatargetdebtratioof0.25.
HighGrowth
Period
Duration
TransitionalPeriod
StableGrowthPeriod
5Years
2Years
Willdecline8%peryear
to
Earningsgrowthrate
45%
5%
5%inthestablegrowth
period
GrowthinCapital
30%
Expenditures
GrowthinDepreciation
ChangeinWorking
Capital
Increasesby8%per
Same$amountas
year
Depreciation
Increasesby13%per
30%
year
GivenBelow
GivenBelow
25%
15%
ShareholderRequired
Return
Capital
Expenditures
$2.25pershareinYear
8
10%
Yr0
Yr1
Yr2
Earningspershare(EPS)
4.55
6.60
9.57
CapitalExpenditures
1.75
2.28
2.96
3.19
3.45
3.73
4.02
4.35
Depreciation
1.05
1.37
1.77
2.01
2.27
2.56
2.89
3.27
0.90
1.10
1.40
1.60
1.80
2.00
2.20
2.10
7.63
Changeinworkingcapital
(WC)
Freecashflowtoequity
(FCFE)
Yr3
Same$amountas
Yr4
Yr5
Yr6
Yr7
WhatisthepresentvalueofBOX,Inc.?
A) $195.71.
B) $212.91.
C) $223.65.
Explanation
Year1FCFE=Earningspershare(CapitalExpendituresDepreciation)(1DebtRatio)(Changeinworkingcapital)(1DebtRatio)
=6.60(2.281.37)(10.25)(1.1)(10.25)=5.09.
Year8FCFE=Earningspershare(CapitalExpendituresDepreciation)(1DebtRatio)(Changeinworkingcapital)(1DebtRatio)
=24.271.050(2.25)(10.25)=23.79.
TheTerminalValue(asofYear7)=23.79/(0.100.05)=475.80.
ThevalueofBOX,Inc.,stockwouldbeequalto:5.09/1.25+7.63/1.252+11.01/[(1.25)2(1.15)1]+14.67/[(1.25)2(1.15)2]+18.08/
[(1.25)2(1.15)3]+20.62/[(1.25)2(1.15)4]+21.89/[(1.25)2(1.15)5]+475.80/[(1.25)2(1.15)5]=
4.07+4.88+6.13+7.10+7.61+7.55+6.97+151.40=195.71
Question#103of145
QuestionID:463216
Dividendspaidouttotheshareholders:
A) arealwayslessthanfreecashflowtoequity(FCFE).
B) maybehigherthanfreecashflowtoequityFCFE.
C) arealwaysequaltofreecashflowtoequity(FCFE).
Explanation
Dividendsrepresentthecashthatthefirmchoosestopaytotheshareholdersandtheamountofthedividendissubjecttothediscretion
ofthefirm.Dividendscanbeequalto,lowerorhigherthanFCFE.Forexample,sometimesfirmsmaypaydividendsinyearswhenthere
isanetloss.
Question#104of145
QuestionID:463177
Freecashflow(FCF)approachesarethebestsourceofvaluewhen:
A) afirmhasnopreferredstock.
B) dividendsarepaidbutdonotreflectthecompany'scapacitytopaydividends.
C) afirmhassignificantminorityinterest.
Explanation
FCFapproachesarebestwhendividendsarepaidbutdonotappeartoberepresentativeofthefirm'scapacitytopaythem.Both
remainingresponseshavenothingtodowiththedecision.
Questions#105110of145
TOY,Inc.isacompanythatmanufacturesdolls,games,andotheritemstoentertainchildren.
ThefollowingtableprovidesbackgroundinformationforTOY,Inc.onapersharebasisintheyear0:
CurrentInformation
Year0
Earnings
$5.00
CapitalExpenditures
$2.40
Depreciation
$1.80
ChangeinWorkingCapital
$1.70
Costofequity
12.0%
Targetdebtratio
30.0%
Marketvalueofstock
$56.00
Sharesoutstanding
5.0million
Interestexpense
$7.2million
Cash&shortterm
investments
Taxrate
$40.0million
37.5%
Earnings,capitalexpenditures,depreciation,andworkingcapitalareallexpectedtogrowby5.0%peryearinthefuture.
Question#105of145
QuestionID:463314
Inyear1,theforecastedfreecashflowtoequity(FCFE)forTOY,Inc.isclosestto:
A) $3.56.
B) $4.53.
C) $4.31.
Explanation
FCFEyear0=Earningspershare[(CapitalExpendituresDepreciation)(1DebtRatio)][(Changeinworkingcapital)(1Debt
Ratio)]=5.00[(2.401.80)(10.30)][(1.70)(10.30)]=3.39.
FCFEforyear1=FCFEyear0(1+growthrate)=3.39(1.05)=$3.56.
(LOS36.d)
Question#106of145
QuestionID:463315
ThevalueofTOY,Inc.'sstockgiventheaboveassumptions,isclosestto:
A) $50.86.
B) $64.71.
C) $61.57.
Explanation
Thevalueofthestock=FCFE1/(rgn)=3.56/(0.120.05)=50.86.
(LOS36.j)
Question#107of145
QuestionID:463316
ComparingthecurrentmarketvalueofTOYtoourestimateofthestock'scurrentmarketvalue,itismostlikelythatatthecurrentmarket
priceof$56.00,TOYInc.stockis:
A) fairlyvalued.
B) undervalued.
C) overvalued.
Explanation
Ourcalculatedvalueofthestock=FCFE1/(rgn)=3.56/(0.120.05)=$50.86.Thecurrentmarketpriceis$56.00,becausethe
marketpriceisgreaterthantheestimatedprice,thestockisovervaluedinthemarket.
(LOS36.m)
Question#108of145
QuestionID:463317
SeniormanagementofTOYInc.isconsideringsellingthecompanytoarivalfirmthathasoffered$450million.Ifthecurrentmarketprice
representsthefairvalueofequityandTOYInc.maintainsitstargetcapitalstructure,thebidrepresentsapricethatis:
A) greaterthanthetotalvalueofthefirm.
B) lessthanthetotalvalueofthefirm.
C) aboutthesametotalvalueofthefirm.
Explanation
Thetotalvalueofafirmisthetotalmarketvalueofequityplusthetotalmarketvalueofdebt.Thetotalvalueofequityis$56.00per
share5,000,000shares=$280million.Equityrepresents70.0%ofthecapitalstructure.Thetotalvalueofthefirmisthus$280
million/0.70=$400million.Anofferof$450millionisapremiumof$50millionapricegreaterthanthecurrentvalueofthefirm.
(LOS36.m)
Question#109of145
QuestionID:463318
TheEV/EBITDAratioforTOYInc.isclosestto:
A) 6.4x.
B) 4.3x
C) 7.1x
Explanation
Thetotalvalueofthefirmisthetotalmarketvalueofequityplusthetotalmarketvalueofdebt.Thetotalvalueofequityis$56.00per
share5,000,000shares=$280.0million.Equityrepresents70.0%ofthecapitalstructure.Thetotalvalueofthefirmis$280.0
million/0.70=$400.0million.Theenterprisevalueisthetotalvalueofthefirmminusthecashandshortterminvestments
$400.0million$40.0million=$360.0million.
Earningsbeforetaxes=$25.0million/(10.375)=$40.0million
EBITDA=$40.0million+$7.2million+$1.805.0millionshares=$56.2million.
EV/EBITDA=$360.0/$56.2=6.4x
(LOS37.n)
Question#110of145
QuestionID:463319
Oneyearlatertheenterprisevalueincreasedby5.0%whiletheEBITDAis$59.0million.IftheEV/EBITDAfortheindustryis7.0,
relativetoitspeers,TOYismostlikely:
A) undervalued.
B) overvalued.
C) fairlyvalued.
Explanation
Thetotalvalueofthefirmisthetotalmarketvalueofequityplusthetotalmarketvalueofdebt.Thetotalvalueofequityis$56.00per
share5,000,000shares=$280.0million.Equityrepresents70.0%ofthecapitalstructure.Thetotalvalueofthefirmis$280.0
million/0.70=$400.0million.Theenterprisevalueforyear0isthetotalvalueofthefirmminusthecashandshortterminvestments
$400.0million$40.0million=$360.0million.Enterprisevalueoneyearlateris$360million(1.05)=$378.0million.
EV/EBITDA=$378.0/$59.0=6.4x.TheEV/EBITDAratioofTOYislessthantheindustryratio.TOYisundervaluedinthemarket.
(LOS37.r)
Question#111of145
QuestionID:463224
Ignoringanycostsrelatedtofinancialdistress,ifafirmincreasesitsfinancialleverage,thevalueofthefirmshould:
A) decreasebecausetherequiredrateofreturnondebtislowerthanthatofequity.
B) increasebecausetheweightedaveragecostofcapitalwillbelowerduetointeresttax
shields.
C) increasebecausetheFCFFwillincrease.
Explanation
Whenafirmaddsleverage,itsvaluemayincreaseduetothetaxshieldsoninterestexpenseandthegenerallylowercostofdebt.In
theory,thereisanoptimalcapitalstructure.Iftheamountofdebtemployedisgreaterthantheoptimal,thecostsassociatedwithriskof
bankruptcyorfinancialdistressbegintooutweightheadvantageofinteresttaxshields.
Question#112of145
QuestionID:463170
Valuationwithfreecashflowtoequityandfreecashflowtothefirm:
A) usedifferentdiscountrates.
B) bothusethecostofequity.
C) bothusetheaftertaxcostofdebt.
Explanation
Freecashflowtothefirmusestheweightedaveragecostofcapitalandfreecashflowtoequityusesthecostofequity.Thekeyisto
useadiscountratethatreflectstheopportunitycostoftheindicatedinvestorgroup.
Question#113of145
QuestionID:463189
ThefollowinginformationisderivedfromthefinancialrecordsofBrownCompanyfortheyearendedDecember31,2004:
Sales
$3,400,000
CostofGoodsSold
(2,100,000)
(COGS)
Depreciation
(300,000)
InterestPaid
(200,000)
GainonSaleofOld
400,000
Equipment
IncomeTaxesPaid
(300,000)
NetIncome
$900,000
BrownissuedbondsonJune30,2004andreceivedproceedsof$4,000,000.
Oldequipmentwithabookvalueof$2,000,000wassoldonAugust15,2004for$2,400,000cash.
BrownpurchasedlandforanewfactoryonSeptember30,2004for$3,000,000,issuinga$2,000,000noteandpayingthebalancein
cash.
Cashflowfromoperationslesscapitalexpendituresis:
A) $6,200,000.
B) $200,000.
C) $2,200,000.
Explanation
Brown'scashflowfromoperations(CFO)was$800,000=($900,000NetIncome+$300,000depreciation$400,000gain).
Capitalexpenditurecashflowswere$3,000,000forthefactoryand$2,400,000cashreceivedfromsaleoftheoldequipmentforanet
outflowofcashof$600,000.
$200,000=($800,000$600,000).
Question#114of145
QuestionID:463320
SudburyIndustriesexpectsFCFFinthecomingyearof400millionCanadiandollars($),andexpectsFCFFtogrowforeveratarateof3
percent.Thecompanymaintainsanallequitycapitalstructure,andSudbury'srequiredrateofreturnonequityis8percent.
SudburyIndustrieshas100millionoutstandingcommonshares.Sudbury'scommonsharesarecurrentlytradinginthemarketfor$80per
share.
UsingtheConstantGrowthFCFFValuationModel,Sudbury'sstockis:
A) undervalued.
B) overvalued.
C) fairlyvalued.
Explanation
Basedonafreecashflowvaluationmodel,SudburyIndustriessharesappeartobefairlyvalued.
SinceSudburyisanallequityfirm,WACCisthesameastherequiredreturnonequityof8%.
ThefirmvalueofSudburyIndustriesisthepresentvalueofFCFFdiscountedbyusingWACC.SinceFCFFshouldgrowataconstant3
percentrate,theresultis:
Firmvalue=FCFF1/WACCg=400million/0.080.03=400million/0.05=$8,000million
Sincethefirmhasnodebt,equityvalueisequaltothevalueofthefirm.Dividingthe$8,000millionequityvaluebythenumberof
outstandingsharesgivestheestimatedvaluepershare:
V0=$8,000million/100millionshares=$80.00pershare
Question#115of145
QuestionID:463220
Whichofthefollowingisleastlikelytochangeasthefirmchangesleverage?
A) Freecashflowstofirm(FCFF).
B) Freecashflowstoequity(FCFE).
C) Weightedaveragecostofcapital(WACC).
Explanation
TheFCFFsarenormallyunaffectedbythechangesinleverage,asthesearethecashflowsbeforethedebtpayments.
Question#116of145
QuestionID:463241
Theonestage(stablegrowth)freecashflowmodelsassume:
A) aconstantgrowthratefornyearsandahighgrowthrateforeverthereafter.
B) therequiredrateofreturnexceedsthegrowthrate.
C) therequiredrateofreturnislessthanthegrowthrate.
Explanation
Theonestagemodelusingeitherfreecashflowtoequity(FCFE)orfreecashflowtothefirm(FCFF)assumesthattherequiredrateof
returnexceedsthegrowthrate.Ifthiswasnotthecase,themodelwouldproduceanunrealisticnegativeprice.
Question#117of145
QuestionID:463198
BOXInc.earned$4.55persharelastyear.Thefirmhadcapitalexpendituresof$1.75pershareanddepreciationexpenseof$1.05.BOX
Inc.hasatargetdebtratioof0.25.
Duration
Earningsgrowthrate
GrowthinCapital
Expenditures
GrowthinDepreciation
HighGrowthPeriod
TransitionalPeriod
2Years
5Years
45%
Willdecline8%peryearto5%
inthestablegrowthperiod
30%
Increasesby8%peryear
30%
Increasesby13%peryear
StableGrowthPeriod
5%
SameasDepreciation
SameasCapital
Expenditures
ChangeinWorkingCapital
ShareholderRequiredReturn
GivenBelow
GivenBelow
$2.25pershareinYear8
25%
15%
10%
Yr0
Yr1
Yr2
Yr3
Yr4
Yr5
Yr6
Yr7
4.55
6.60
9.57
13.11
16.91
20.46
23.12
24.27
1.75
2.28
2.96
3.19
3.45
3.73
4.02
4.35
Depreciation
1.05
1.37
1.77
2.01
2.27
2.56
2.89
3.27
ChangeinWC
0.90
1.10
1.40
1.60
1.80
2.00
2.20
2.10
7.63
11.01
14.67
18.08
20.62
21.89
EPS
Capital
Expenditures
FCFE
Inyear1,whatisthefreecashflowtoequity(FCFE)forBOXInc.?
A) $6.10.
B) $3.35.
C) $5.09.
Explanation
Year1FCFE=Earningspershare(CapitalExpendituresDepreciation)(1DebtRatio)Changeinworkingcapital(1DebtRatio)
Year1FCFE=6.60(2.281.37)(10.25)(1.1)(10.25)=5.09
Question#118of145
QuestionID:463226
Inwhatwaysaredividendsdifferentfromfreecashflowtoequity(FCFE)?
A) CompaniesoftenuseFCFEasasignalofpositivefuturegrowthprospectswhile
dividendsarenotusedforsignaling.
B) Dividendsareoftenviewedas"sticky."Managersarereluctanttoradicallychangethe
dividendpayoutpolicywhileFCFEoftenhasimmensevariability.
C) Thereisnodifference.DividendsmustequalFCFE.
Explanation
DividendsandtheFCFEareoftendifferentanddividendsareusedasasignaltothemarketnotFCFE.Dividendsviewedasstickyisthe
truestatement.
Question#119of145
Therepaymentofasignificantamountofoutstandingdebtwillcausefreecashflowtoequity(FCFE)to:
A) decrease.
B) remainthesame.
QuestionID:463223
C) increase.
Explanation
Debtrepaymentwilldecreasenetborrowingand,hence,decreaseFCFEbecause:FCFE=FCFF[interestexpense](1taxrate)+net
borrowing.
Question#120of145
QuestionID:463214
TheestimateofvaluefromFCFEmodelswillalwaysbedifferentthanthevalueobtainedusingDDM,if:
A) FCFEishigherthandividends,andtheexcessisinvestedinzeroNPVprojects.
B) FCFEishigherthandividends.
C) FCFEisgreaterthandividends,andtheexcessisnotinvestedinzeroNPVprojects.
Explanation
TheestimateofvaluefromFCFEmodelswillalwaysbedifferentfromthevalueobtainedusingDDM,iftheFCFEisgreaterthan
dividends,andtheexcesscashisnotinvestedinzeroNPVprojects.
Question#121of145
QuestionID:463186
Acontrolperspectiveismostconsistentwithwhichofthefollowingvaluationapproaches?
A) Freecashflow(FCF).
B) Dividends.
C) Pricetoenterprisevalue.
Explanation
Dividendpolicycanbechangedbythebuyerofafirm.Thus,theFCFperspectivelookstothesourceofdividendsinapositionofcontrol
ratherthandirectlyatdividends.Thepricetoenterprisevalueapproachdoesnotfocusoncashflows.
Question#122of145
QuestionID:463240
Afirminstablegrowthphaseshouldhave:
A) capitalexpendituresthatarelessthanthedepreciationexpense.
B) agrowthratehigherthanthatoftheeconomyandarequiredrateofreturnthatisgreaterthan
themarketrateofreturn.
C) arequiredrateofreturnclosetothemarketrateofreturnandcapitalexpendituresthatarenot
toolargerelativetodepreciationexpense.
Explanation
Afirmthatisinastablegrowthphaseshouldhavegrowthrateclosetothatoftheeconomy,andthecostofequityshouldapproximate
therequiredrateofreturnonthemarket.Inaddition,thecapitalexpendituresshouldnotbedisproportionatelylargerelativetothe
depreciationexpense.
Questions#123128of145
AshleyWinters,CFA,hasbeenhiredtovalueGoliathCommunications,acompanythatiscurrentlyexperiencingrapidgrowthand
expansion.Wintersisanexpertinthecommunicationsindustryandhashadextensiveexperienceinvaluingsimilarfirms.Sheis
convincedthatavaluefortheequityofGoliathcanbereliablyobtainedthroughtheuseofathreestagefreecashflowtoequity(FCFE)
modelwithdeclininggrowthinthesecondstage.Basedonuptodatefinancialstatements,shehasdeterminedthatthecurrentFCFEper
shareis$0.90.WintershaspreparedaforecastofexpectedgrowthratesinFCFEasfollows:
Stage1: 10.5%foryears1through3
Stage2: 8.5%inyear4,6.5%inyear5,5.0%inyear6
Stage3: 3.0%inyear7andthereafter
Moreover,shehasdeterminedthatthecompanyhasabetaof1.8.Thecurrentriskfreerateis3.0%,andtheequityriskpremiumis
5.0%.
Otherfinancialinformation:
Outstandingshares
10million
Taxrate
40.0%
Interestexpense
$750,000
Netborrowing
$100,000
Costofdebt
7.5%
Debttoequityratio
25.0%
Estimatedgrowthrateforthefirm
4.0%
Question#123of145
QuestionID:463293
Therequiredreturnisclosestto:
A) 9.0%.
B) 6.6%.
C) 12.0%
Explanation
BasedontheCAPMwecanestimatearequiredreturnonequityas:
Requiredreturn=3.0%+1.8(5.0%)=12%
(LOS31.c)
Question#124of145
Theterminalvalueinyear6isclosestto:
A) $16.86.
B) $25.29.
C) $21.68.
QuestionID:463294
Explanation
EstimatesforthefutureFCFEbasedonsuppliedgrowthratesare:
Year
8.5%
6.5%
5.0%
3.0%
Growthrate
FCFE/share
R$=1.518/(12.0%3.0%)=16.861
(LOS36.e)
Question#125of145
QuestionID:463295
ThepersharevalueWintersshouldassigntoGoliath'sequityisclosestto:
A) $13.55.
B) $16.87.
C) $20.24.
Explanation
Wefindthevalueoftheequity/sharebydiscountingallfutureFCFE/sharebytherequiredrateofreturnonequity.
Usingourcalculator,enterCF0=0C01=0.995C02=1.099C03=1.214C04=1.318C05=1.403C06=1.473+16.867=18.34I
=12ComputeNPV=13.55.
(LOS36.j)
Question#126of145
QuestionID:463296
Thefreecashflowtothefirm(FCFF)isclosestto:
A) $9.45million.
B) $9.35million.
C) $9.55million.
Explanation
FCFEof$0.90pershareisgiven.Thereare10millionsharesoutstanding.ThetotalFCFEis$0.9010,000,000=$9,000,000.
TheformulaforFCFEisFCFE=CFO+FCInv+Netborrowing,andtheformulaforFCFFisFCFF=CFO+FCInv+interestexpense
(1taxrate)
FCFF=FCFENetborrowing+interestexpense(1taxrate)=$9million($100,000)+$750,000(10.40)=$9.55million
(LOS36.d)
Question#127of145
Theweightedaveragecostofcapital(WACC)isclosestto:
QuestionID:463297
A) 10.5%.
B) 11.1%.
C) 10.9%.
Explanation
Thedebttoequityratioof25.0%meansthatthedebttototalvalueis25.0%/125.0%or20.0%.Theweightofdebtisthus20.0%andthe
weightofequityis80.0%.
TheWACC=[0.20(0.075)(10.40)]+(0.800.12)=10.5%
(LOS36.j)
Question#128of145
QuestionID:463298
Thevalueofthefirm,basedontheconstantgrowthmodel,isclosestto:
A) $124million
B) $140million.
C) $153million.
Explanation
TheestimatedFCFFforyear0is$9.55millionandtheWACCis10.5%ascalculated.Ifthegrowthrateforthefirmisestimatedas4.0%,
thevalueofthefirmis:
$9.55million(1.04)/(0.1050.04)=$152,800,000.
(LOS36.j)
Question#129of145
QuestionID:463191
Freecashflowtothefirm(FCFF)adjustsearningsbeforeinterestandtaxes(EBIT)by:
A) subtractinginvestmentsinfixedcapitalandworkingcapital.
B) addingtaxes,deductingdepreciation,andaddingbacktheinvestmentsinfixedcapitaland
workingcapital.
C) deductingtaxes,addingbackdepreciation,anddeductingtheinvestmentsinfixedcapitaland
workingcapital.
Explanation
Aspresentedinthereading:FCFF=EBIT(1taxrate)+DepFCInvWCInv.
Question#130of145
QuestionID:463227
Iftheinvestmentinfixedcapitalandworkingcapitaloffseteachother,freecashflowtothefirm(FCFF)maybeproxiedby:
A) earningsbeforeinterestandtaxes(EBIT).
B) netincomeplusnoncashchargesplusaftertaxinterest.
C) netincomeplusaftertaxinterest.
Explanation
TheanswerisindicatedbythedefinitionofFCFF:FCFF=NI+NCC+Int(1taxrate)FCInvWCInv.Therelationshipbetweennet
incomeandFCFFisindicatedby:NI=EBIT(1taxrate)Int(1taxrate).
Question#131of145
QuestionID:463234
ThethreestageFCFEmodelmightresultinanextremelyhighvalueif:
A) thegrowthrateinthestableperiodistoohigh.
B) thegrowthrateinthestableperiodisequaltothatofGNP.
C) thegrowthrateinthestableperiodistoolow.
Explanation
Ifthegrowthrateinthestableperiodistoohighorthehighgrowthandtransitionperiodsaretoolong,thethreestageFCFEmodelmight
resultinanextremelyhighvalue.
Question#132of145
QuestionID:463238
Thestablegrowthfreecashflowtothefirm(FCFF)modelismostusefulinvaluingfirmsthat:
A) havecapitalexpendituresthatarenotsignificantlyhigherthandepreciation.
B) havecapitalexpendituresthataresignificantlyhigherthandepreciation.
C) aregrowingataratesignificantlylowerthanthatoftheoveralleconomy.
Explanation
ThestablegrowthFCFFmodelisusefulforvaluingfirmsthatareexpectedtohavegrowthratesclosetothatoftheoveralleconomy.
Sincetherateofgrowthapproximatesthatfortheoveralleconomy,thesefirmsshouldhavecapitalexpendituresthatarenotsignificantly
differentthandepreciation.
Question#133of145
QuestionID:463229
Assumingthattheinvestmentinfixedcapitalandworkingcapitaloffseteachother,freecashflowtothefirm(FCFF)maybeproxiedby
netincomeif:
A) earningsbeforeinterestandtaxes(EBIT)equalsdepreciation.
B) noncashchargesandinterestchargesareequal.
C) noncashchargesandinterestchargesarezero.
Explanation
TheanswerisshownbytherelationshipbetweenFCFFandnetincome:FCFF=NI+NCC+Int(1taxrate)FCInvWCInv.Further:
FCFF=EBIT(1taxrate)+DepFCInvWCInv,whichassumesthatdepreciationistheonlynoncashcharge.
Question#134of145
QuestionID:463245
ThetwostageFCFEmodelissuitableforvaluingfirmsthat:
A) havemoderategrowthintheinitialphasethatdeclinesgraduallytoastablerate.
B) haveveryhighbutdeclininggrowthrateintheinitialstage.
C) areinanindustrywithsignificantbarrierstoentry.
Explanation
ThetwostageFCFEmodelissuitableforvaluingfirmsinindustrieswithsignificantbarrierstoentry.Wherethesearepresentitis
possibleforthefirmtomaintainahighgrowthrateduringaninitialphaseoflowcompetition,andthattheratewilldropsharplytoa
normalizedratewhencompetitionultimatelyappears.
Question#135of145
QuestionID:463276
IndustrialLightcurrentlyhas:
Expectedfreecashflowtothefirminoneyear=$4.0million.
Costofequity=12%.
Weightedaveragecostofcapital=10%.
Totaldebt=$30.0million.
Longtermexpectedgrowthrate=5%.
Whatisthevalueofequity?
A) $44,440,000.
B) $80,000,000.
C) $50,000,000.
Explanation
Theoverallvalueofthefirmis$4,000,000/(0.100.05)=$80,000,000.Thus,thevalueofequityis$80,000,000$30,000,000=
$50,000,000.
Question#136of145
QuestionID:463197
SOXInc.expectshighgrowthinthenext4yearsbeforeslowingtoastablefuturegrowthof3%.Thefirmisassumedtopaynodividends
inthenearfutureandhasthefollowingforecastedfreecashflowtoequity(FCFE)informationonapersharebasisinthehighgrowth
period:
FCFE
Year1
Year2
Year3
Year4
$3.05
$4.10
$5.24
$6.71
Highgrowthperiodassumptions:
SOXInc.'stargetdebtratiois40%andabetaof1.3.
ThelongtermTreasuryBondRateis4.0%,andtheexpectedequityriskpremiumis6%.
Stablegrowthperiodassumptions:
SOXInc.'stargetdebtratiois40%andabetaof1.0.
ThelongtermTreasuryBondRateis4.0%andtheexpectedequityriskpremiumis6%.
Capitalexpendituresareassumedtoequaldepreciation.
Inyear5,earningsare$8.10persharewhilethechangeinworkingcapitalis$2.00pershare.
Earningsandworkingcapitalareexpectedtogrowby3%ayearinthefuture.
Inyear5,whatisthefreecashflowtoequity(FCFE)forSOXInc.?
A) $6.10.
B) $7.30.
C) $6.90.
Explanation
Inyear5,FCFE=Earningspershare(CapitalExpendituresDepreciation)(1DebtRatio)(Changeinworkingcapital)(1Debt
Ratio)=8.100(10.4)2.00(10.4)=6.90.
Question#137of145
QuestionID:463228
Iftheinvestmentinfixedcapitalandworkingcapitaloffseteachother,freecashflowtothefirm(FCFF)maybeproxiedby:
A) netincomeplusaftertaxinterest.
B) earningsbeforeinterestandtaxes(EBIT).
C) aftertaxEBITplusnoncashcharges.
Explanation
TheanswerisindicatedbythedefinitionofFCFF:FCFF=EBIT(1taxrate)+DepFCInvWCInv,whichassumesthatdepreciationis
theonlynoncashcharge.Further:FCFF=NI+NCC+Int(1taxrate)FCInvWCInv.
Question#138of145
Whichofthefollowingismostusefulinanalyzingfirmsthathavehighleverageandhighgrowth?
A) Twostagefreecashflowtothefirm(FCFF)model.
B) Stablegrowthfreecashflowtothefirm(FCFF)model.
C) Twostagefreecashflowtoequity(FCFE)model.
Explanation
QuestionID:463239
Ofthecashflowvaluationmodelsmentionedabove,thetwostageFCFFmodelismostusefulinanalyzingthefirmsthathavehigh
leverageandhighgrowth.Thehighgrowthwillmakethestablegrowthmodelsinapplicable,whilethehighleveragemakestheFCFF
modelmoreattractive.
Question#139of145
QuestionID:463188
Theownershipperspectiveimplicitinthefreecashflowtoequityvaluationapproachisof:
A) control.
B) apreferredstockholder.
C) aminorityposition.
Explanation
Dividendpolicycanbechangedbythebuyerofafirm.Thus,thefreecashflowperspectivelookstothesourceofdividendsinaposition
ofcontrolratherthandirectlyatdividends.
Question#140of145
QuestionID:463275
Afirmhasprojectedfreecashflowtoequitynextyearof$1.25pershare,$1.55intwoyears,andaterminalvalueof$90.00twoyears
fromnow,aswell.Giventhefirm'scostofequityof12%,aweightedaveragecostofcapitalof14%,andtotaloutstandingdebtof$30.00
pershare,whatisthecurrentvalueofequity?
A) $74.10.
B) $71.74.
C) $41.54.
Explanation
Valueofequity=$1.25/(1.12)1+$1.55/(1.12)2+$90.00/(1.12)2=$74.10
Question#141of145
QuestionID:463255
SOX,Inc.,expectshighgrowthinthenext4yearsbeforeslowingtoastablefuturegrowthof3%.Thefirmisassumedtopayno
dividendsinthenearfutureandhasthefollowingforecastedfreecashflowtoequity(FCFE)informationonapersharebasisinthehigh
growthperiod:
Year1 Year2 Year3 Year4
FCFE $3.05 $4.10 $5.24 $6.71
Highgrowthperiodassumptions:
SOX,Inc.'s,targetdebtratiois40%andabetaof1.3.
ThelongtermTreasuryBondRateis4.0%,andtheexpectedequityriskpremiumis6%.
Stablegrowthperiodassumptions:
SOX,Inc.'s,targetdebtratiois40%andabetaof1.0.
ThelongtermTreasuryBondRateis4.0%andtheexpectedequityriskpremiumis6%.
Capitalexpendituresareassumedtoequaldepreciation.
Inyear5,earningsare$8.10persharewhilethechangeinworkingcapitalis$2.00pershare.
Earningsandworkingcapitalareexpectedtogrowby3%ayearinthefuture.
WhatisthepresentvalueonapersharebasisforSOX,Inc.?
A) $64.24.
B) $70.49.
C) $77.15.
Explanation
Therequiredrateofreturninthehighgrowthperiodis(r)=0.04+1.3(0.06)=0.118.
Therequiredrateofreturninthestablegrowthperiodis(r)=0.04+1.0(0.06)=0.10.
ThePresentValue(PV)oftheFCFEinthehighgrowthperiodis(3.05/1.118)+(4.10/1.1182)+(5.24/1.1183)+(6.71/1.1184)=14.06.
Question#142of145
QuestionID:463246
Thetwostage(stablegrowth)freecashflowtoequity(FCFE)andfreecashflowtothefirm(FCFF)modelstypicallyassume:
A) therequiredrateofreturnequalsthegrowthrateinthelaststage.
B) ahighgrowthratefornyearsandthenaconstantgrowthrateforeverthereafter.
C) therequiredrateofreturnislessthanthegrowthrateinthelaststage.
Explanation
ThetwostagemodelusingeitherFCFEorFCFFtypicallyassumesahighgrowthratefornyearsandthenaconstantgrowthrateforever
thereafter.Multistagemodelsassumethattherequiredrateofreturnexceedsthegrowthrateinthelaststage.
Question#143of145
QuestionID:463215
Whichofthefollowingstatementsisleastaccurate?Afirm'sfreecashflowstoequity(FCFE)isthecashavailabletostockholdersafter
funding:
A) dividendpayments.
B) debtprincipalrepayments.
C) capitalexpenditurerequirements.
Explanation
Afirm'sFCFEisthecashavailabletostockholdersafterfundingcapitalexpendituresanddebtprincipalrepayments.
Question#144of145
QuestionID:463306
Afirmhas:
Freecashflowtoequity=$4.0million.
Costofequity=12%.
Longtermexpectedgrowthrate=5%.
Valueofequitypershare=$57.14pershare.
Whatwillhappentothevalueofequityifthecostofequitydecreasesto10%?
A) Thevaluewilldecrease.
B) Thereisinsufficientinformationtotell.
C) Thevaluewillincrease.
Explanation
Everythingelsebeingconstant,adecreaseintherelevantrequiredrateofreturnshouldincreasethevalueoftheequitypershare.
Question#145of145
Freecashflowtoequityvaluationuseswhichdiscountrate?
A) Weightedaveragecostofcapital.
B) Costofequity.
C) Aftertaxcostofdebt.
Explanation
Freecashflowtoequityvaluationusestheopportunitycostrelevanttostockholders,whichisthecostofequity.
QuestionID:463175