04 free cash flow valuation

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Test ID: 7441130 Free Cash Flow Valuation Question #1 of 145 Question ID: 463221 A) B) C) An analyst has prepared the following scenarios for Schneider, Inc.: Scenario 1 Assumptions: Tax rate is 40%. Weighted average cost of capital (WACC) = 12%. Constant growth rate in free cash flow = 3%. Last year, free cash flow to the firm (FCFF) = $30. Target debt ratio = 10%. Scenario 2 Assumptions: Tax rate is 40%. Expenses before interest and taxes (EBIT), capital expenditures, and depreciation will grow at 15% for the next three years. After three years, the growth in EBIT will be 2%, and capital expenditure and depreciation will offset each other. WACC during high growth stage = 20%. WACC during stable growth stage = 12%. Target debt ratio = 10%. Scenario 2 FCFF Year 0 (last year) Year 1 Year 2 Year 3 Year 4 EBIT $15.00 $17.25 $19.84 $22.81 $23.27 Capital Expenditures 6.00 6.90 7.94 9.13 Depreciation 4.00 4.60 5.29 6.08 Change in Working Capital 2.00 2.10 2.20 2.40 2.40 FCFF 5.95 7.06 8.25 11.56 Assuming that Schneider, Inc., slightly increases its financial leverage, what should happen to its firm value? The firm value should: increase due to the additional value of interest tax shields. not change because financial leverage has no relationship with firm value. decline due to the increase in risk. Explanation For small changes in leverage, the additional value added by the interest tax shields will more than offset the additional risk of bankruptcy / financial distress. Given the tax advantage of debt, the firm's WACC should decline, not increase with small changes in leverage.

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  • TestID:7441130FreeCashFlowValuation

    Question#1of145 QuestionID:463221

    A)

    B)

    C)

    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.WACCduringhighgrowthstage=20%.WACCduringstablegrowthstage=12%.Targetdebtratio=10%.

    Scenario2FCFF

    Year0

    (last

    year)

    Year1 Year2 Year3 Year4

    EBIT $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

    FCFF 5.95 7.06 8.25 11.56

    AssumingthatSchneider,Inc.,slightlyincreasesitsfinancialleverage,whatshouldhappentoitsfirmvalue?Thefirmvalueshould:

    increaseduetotheadditionalvalueofinteresttaxshields.

    notchangebecausefinancialleveragehasnorelationshipwithfirmvalue.

    declineduetotheincreaseinrisk.

    Explanation

    Forsmallchangesinleverage,theadditionalvalueaddedbytheinteresttaxshieldswillmorethanoffsettheadditionalriskofbankruptcy

    /financialdistress.Giventhetaxadvantageofdebt,thefirm'sWACCshoulddecline,notincreasewithsmallchangesinleverage.

  • Questions#27of145

    Question#2of145 QuestionID:463279

    A)

    B)

    C)

    Question#3of145 QuestionID:463280

    A)

    B)

    C)

    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.

    Thefirm'searningsgrowthrateismostaccuratelyestimatedas:

    6.4%.

    4.8%.

    8.0%.

    Explanation

    Thefirm'sestimatedearningsgrowthrateistheproductofitsretentionratioandROE:

    g=RR(ROE)=[(600120)/600](600/6000)=0.08(LOS35.o)

    The2013forecastedfreecashflowtoequityis:

    $300M.

    $420M.

    $340M.

    Explanation

    Sinceworkingcapitalneedsarenegligible,thefreecashflowtoequityis:

    FCFE=Netincome[1DR)][FCInvDepreciation][(1DR)WCInv]FCFE=600M[10.4](800M500M)=420M

    where:DR=targetdebttoassetratio(LOS36.d)

  • Question#4of145 QuestionID:463281

    A)

    B)

    C)

    Question#5of145 QuestionID:463282

    A)

    B)

    C)

    Question#6of145 QuestionID:463283

    A)

    B)

    C)

    Question#7of145 QuestionID:463284

    Ifthetotalmarketvalueofequityis$6.0billionandthegrowthrateis8.0%,thecostofequitybasedonthestablegrowthFCFEmodelis

    closestto:

    15.0%.

    7.6%.

    15.6%.

    Explanation

    Valueofequity=FCFE /(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)

    ThebetaforHTCis1.056,theriskfreerateis5.0%andthemarketriskpremiumis10.0%.TheweightedaveragecostofcapitalforHTC

    isclosestto:

    11.74%.

    13.34%.

    15.56%.

    Explanation

    Costofequity=r +(r r )=0.05+1.056(0.10)=0.05+0.1056=0.1556

    Thebestapproximationforcostofdebtistheinterestexpensedividedbythemarketvalueofthedebt.

    Costofdebt=Interestexpense/marketvalueofdebt=$400million/$4.0billion=0.10

    WACC=w r (1t)+were=0.400.10(10.40)+0.600.1556=0.1174(LOS36.j)

    ThemostappropriatestrategyformulationstyleforHTCis:

    Adaptive

    Classical

    Shaping

    Explanation

    Industrydemandiscyclicalbutforecasterrorstendtobelowindicatingpredictablebusinessenvironment.Wearealsogiventhat

    malleabilityislow.HenceClassicalstylewouldbemostappropriate.(LOS33.c)

    FCFEfor2013is$400.0millionandHTCtookonanadditionaldebtof$40.0millionwhilerepayingexistingdebtof$60.0million.ThegrowthrateforFCFFis5.0%andtheWACCis11.5%.Thevalueofthefirmcalculatedusingthestablegrowthmodelismostaccuratelydescribedas:

    1

    f m f

    d d

  • A)

    B)

    C)

    Question#8of145 QuestionID:463199

    A)

    B)

    C)

    Question#9of145 QuestionID:463244

    A)

    B)

    C)

    Question#10of145 QuestionID:463232

    A)

    lessthanthemarketvalueofthefirmby$3.3billion.

    lessthanthemarketvalueofthefirmby$7.5billion.

    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)

    Afirmcurrentlyhassalespershareof$10.00,andexpectssalestogrowby25%nextyear.Thenetprofitmarginisexpectedtobe15%.

    Fixedcapitalinvestmentnetofdepreciationisprojectedtobe65%ofthesalesincrease,andworkingcapitalrequirementsare15%ofthe

    projectedsalesincrease.Debtwillfinance45%oftheinvestmentsinnetcapitalandworkingcapital.Thecompanyhasan11%required

    rateofreturnonequity.Whatisthefirm'sexpectedfreecashflowtoequity(FCFE)persharenextyearundertheseassumptions?

    $0.38.

    $1.88.

    $0.77.

    Explanation

    FCFE=netprofitNetFCInvWCInv+DebtFin=$1.88$1.630.38+0.90=0.77

    InusingFCFEmodels,theassumptionofgrowthshouldbe:

    independentfromtheassumptionsofothervariables.

    onlyconsistentwiththeassumptionsofcapitalspendinganddepreciation.

    consistentwithassumptionsofothervariables.

    Explanation

    Theassumptionofgrowthshouldbeconsistentwithassumptionsaboutothervariables.Netcapitalexpenditures(capitalexpendituresminusdepreciation)andbeta(risk)usedtocalculaterequiredrateofreturnshouldbeconsistentwithassumedgrowthrate.

    WhichofthefollowingstatementsaboutthethreestageFCFEmodelismostaccurate?

    Thereisafinalphasewhengrowthratestartstodecline.

  • B)

    C)

    Questions#1116of145

    Thereisatransitionperiodwherethegrowthratedeclines.

    Thereisatransitionperiodwherethegrowthrateisstable.

    Explanation

    InthethreestageFCFEmodel,thereisaninitialphaseofhighgrowth,atransitionperiodwherethegrowthratedeclines,andasteadystateperiodwheregrowthisstable.

    MichaelBallmerisanequityanalystwithNewHorizonResearch.Thefirmhashistoricallyreliedondividendandresidualincomevaluationmodelstovalueequity,butthefirm'sdirectorofresearch,DougLeads,hasdecidedthatthefirmneedstoincorporatefreecashflowvaluationsintoitspractices.Therefore,LeadsdecidestosendBallmertoaseminaronfreecashflowvaluation.

    Uponhisreturnfromtheconvention,Ballmerisexcitedtosharehisnewfoundknowledgewithhiscoworkers.BallmerisaskedtogiveadebriefingtoNewHorizon'steamofequityanalysts,wherehemakesthefollowingstatements:

    Statement1:

    Freecashflowtothefirmistheamountofthefirm'scashflowthatisfreeforthefirmtouseinmakinginvestmentsaftercashoperating

    expenseshavebeencovered.

    Statement2:

    Freecashflowtoequity,then,istheamountofthefirm'scashflowthatisfreeforequityholdersaftercoveringcashoperatingexpenses,

    workingcapitalandfixedcapitalinvestments,interestprincipalpaymentstobondholders,andrequireddividedpayments.

    Statement3:

    Oneofthebenefitsoffreecashflowvaluationisthatthevalueofthefirmandthevalueofequitycanbefoundbydiscountingfreecashflowtothefirmandfreecashflowtoequity,respectively,bythe

    WACC.

    Aspartofhispresentation,Ballmerincludesashortexampleofhowtocalculatefreecashflowtoequity.Thefiguresfromhisexampleareincludedbelow.

    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

  • Question#11of145 QuestionID:463179

    A)

    B)

    C)

    Question#12of145 QuestionID:463180

    A)

    Longtermdebt $4,528 $5,039

    Commonstock $729 $735

    Retainedearnings $15,725 $15,093

    Totalliabilitiesandowner'sequity

    $28,337 $28,406

    Figure2:ExampleCashFlowFromOperations

    20X2 20X1

    Netincome $1,783 $2,195

    Depreciation $376 $267

    WCInv ($178) $357

    Cashflowfromoperations

    $2,337 $2,819

    Afterdiscussingthecalculationoffreecashflowtothefirmandfreecashflowtoequityfromhistoricalinformation,Ballmerproceedstoexplainthemajorapproachesforforecastingfreecashflow.Hefocuseshisdiscussiononforecastingthecomponentsoffreecashflowasthismethodismoreflexible.Duringhispresentation,severaloftheanalystsnoticethattheformulaforforecastingfreecashflowtoequitydoesnotincludenetborrowing.TheybringthistoBallmer'sattention,andhestatesthathewilllookintotheformulaandsendoutanupdatedpresentationafterthemeeting.

    Aweekafterthemeeting,JonathanHodgesapproachedBallmerregardingtwoissueshehadwhileapplyingfreecashflowbasedvaluations.ThefirstissuethatHodgeshadwasthathecalculatedtheequityvalueofafirmusingbothfreecashflowtoequitybasedanddividendbasedvaluationsandarrivedatdifferentvalues.ThesecondissuethatHodgescameacrosswastheeffectofachangeinafirm'stargetleverageonFCFE.OneofthefirmsthatHodgeswasanalyzingmayreduceleverage,andHodgesneedstoknowifthiswillaffecthisvaluation.

    Regardingstatements1and2,areBallmer'sinterpretationsoffreecashflowtothefirm(FCFF)andfreecashflowtoequity(FCFE)CORRECT?

    No,neitherinterpretationiscorrect.

    No,onlyoneinterpretationiscorrect.

    Yes,bothinterpretationsarecorrect.

    Explanation

    Freecashflowtothefirm(FCFF)isthecashflowsthatarefreetoinvestorsaftercashoperatingexpenses(includingtaxesbutexcludinginterestexpense),workingcapitalinvestments,andfixedcapitalinvestmentshavebeenmade.Freecashflowtoequity(FCFE)isFCFFlessinterestpaymentstobondholdersandnetborrowingfrombondholders.(StudySession12,LOS36.a)

    IsBallmer'sthirdstatementregardingthecomputationoffirmvalueandequityvalueCORRECT?

    Yes.

  • B)

    C)

    Question#13of145 QuestionID:463181

    A)

    B)

    C)

    Question#14of145 QuestionID:463182

    A)

    B)

    C)

    Question#15of145

    No,freecashflowtoequityshouldbediscountedattherequiredreturnonequity.

    No,bothfreecashflowtothefirmandfreecashflowtoequityshouldbediscountedattherequiredrateofreturnonequity.

    Explanation

    Thevalueofafirmistheexpectedfuturefreecashflowtothefirm(FCFF)discountedatthefirm'sweightedaveragecostofcapital(WACC).Thevalueofthefirm'sequityistheexpectedfuturefreecashflowtoequitydiscountedattherequiredreturnonequity.(StudySession12,LOS36.d)

    Basedonfigures1and2,the20X2freecashflowtoequity(FCFE)forBallmer'sexamplefirmis:

    $1,010.

    $1,693.

    $1,544.

    Explanation

    Freecashflowtoequity(FCFE)canbecomputedas:

    FCFE=CFOFCInv+netborrowing

    Basedonthefiguresincludedintheexample,fixedcapitalinvestment(FCInv)is$223(=$22,499$22,722)andnetborrowingis$1,016(=$2,491+$4,528$2,996$5,039).

    FCFEistherefore:FCFE=$2,337+$223$1,016=$1,544.(StudySession12,LOS36.d)

    WhichofthefollowingstatementsregardingforecastingFCFEusingthecomponentsoffreecashflowmethodandnetborrowingismostaccurate?

    Investmentinfixedcapitalandnetborrowingareassumedtooffseteachother.

    Netincomealreadyaccountsforinterestexpensetherefore,netborrowingisnotneeded.

    Thetargetdebttoassetratioaccountsforthefinancingofnewinvestmentinfixedcapitalandworkingcapital.

    Explanation

    WhenforecastingFCFE,itiscommontoassumethatafirmwillmaintainatargetdebttoassetratiofornewinvestmentsinfixedcapitalandworkingcapital.Basedonthisassumption,theformulaforforecastingFCFEis:

    FCFE=NI&8722[(1DR)(FCInvDep)][(1DR)WCInv]

    Bymultiplyingthefixedcapitalandworkingcapitalinvestmentsbyoneminusthetargetdebttoassetratio,youareleftwiththeinvestmentamountlesstheamountfinancedbydebt,whichisthenetborrowingamount.Therefore,thisformulaaccountsfornetborrowingthroughthetargetdebttoassetratio.(StudySession12,LOS36.e)

  • QuestionID:463183

    A)

    B)

    C)

    Question#16of145 QuestionID:463184

    A)

    B)

    C)

    Question#17of145 QuestionID:463243

    A)

    B)

    C)

    Question#18of145 QuestionID:463225

    Shoulddividendbasedandfreecashflowfromequity(FCFE)basedvaluationsresultindifferentequityvaluesforafirm?

    Yes,dividendbasedvaluationswouldbehigherforfirmswithlarge,consistentdividends.

    Yes,thefreecashflowfromequityvaluationwouldbehigheriftherewereapremiumassociatedwithcontrolofthefirm.

    No,bothmodelsshouldresultinthesamevalue.

    Explanation

    TheownershipperspectivesofdividendbasedandFCFEbasedvaluationsaredifferent.Dividendbasedvaluationstaketheperspectiveofminorityshareholders,whileFCFEbasedvaluationstaketheperspectiveofanacquirerwhowillassumeacontrollingpositioninthefirm.Ifinvestorswerewillingtopayapremiumforacontrollingpositioninthefirm,thentheequityvaluecomputedundertheFCFEapproachwouldbehigher.(StudySession12,LOS36.b)

    Whichofthefollowingstatementsregardingtheeffectadecreaseinleveragehasonafirm'sfreecashflowfromequity(FCFE)ismostaccurate?

    FCFEisunaffectedbychangesinleverage.

    CurrentyearFCFEincreases,butfutureFCFEwillbereduced.

    CurrentyearFCFEdecreases,butfutureFCFEwillbeincreased.

    Explanation

    ChangesinleveragedohaveasmalleffectonFCFE.AdecreaseinleveragewillcausethecurrentyearFCFEtodecreasethroughtherepaymentofdebt.FutureFCFEwillbeincreasedbecauseinterestexpensewillbelower.(StudySession12,LOS36.g)

    Athreestagefreecashflowtothefirm(FCFF)istypicallyappropriatewhen:

    growthiscurrentlylowandwillmovethroughatransitionalstagetoafinalstage

    whereingrowthexceedstherequiredrateofreturn.

    growthiscurrentlyhighandwillmovethroughatransitionalstagetoasteadystategrowth

    rate.

    therequiredrateofreturnislessthanthegrowthrateinthelaststage.

    Explanation

    ThethreestagemodelusingeitherFCFEorFCFFtypicallyassumesthatgrowthiscurrentlyhighandwillmovethroughatransitional

    stagetoasteadystategrowthrate.Multistagemodelsassumethattherequiredrateofreturnexceedsthegrowthrateinthelaststage.

  • A)

    B)

    C)

    Questions#1924of145

    Whichofthefollowingstatementsregardingdividendsandfreecashflowtoequity(FCFE)isleastaccurate?

    FCFEcanbenegativebutdividendscannot.

    RequiredreturnsarehigherinFCFEdiscountmodelsthantheyareindividenddiscount

    models,sinceFCFEismoredifficulttoestimate.

    FCFEdiscountmodelsusuallyresultinhigherequityvaluesthandodividenddiscountmodels

    (DDMs).

    Explanation

    AlthoughFCFEmaybemoredifficulttoestimatethandividends,therequiredreturnisbasedontheriskfacedbytheshareholders,which

    wouldbethesameunderbothmodels.

    AnanalysthaspreparedthefollowingscenariosforSchneiderInc.:

    Scenario1Assumptions:

    TaxRateis40%.Weightedaveragecostofcapital(WACC)=12.0%.Constantgrowthrateinfreecashflow(FCF)=3.0%.Year0,freecashflowtothefirm(FCFF)=$30.0millionTargetdebtratio=10.0%.

    Scenario2Assumptions:

    TaxRateis40.0%.Expensesbeforeinterestandtaxes(EBIT),capitalexpenditures,anddepreciationwillgrowat20.0%forthenextthreeyears.Afterthreeyears,thegrowthinEBITwillbe2.0%,andcapitalexpenditureanddepreciationwilloffseteachother.Weightedaveragecostofcapital(WACC)=12.0%Targetdebtratio=10.0%.

    Scenario2FCFF(in$millions)Year0

    Year0

    Year1 Year2 Year3 Year4

    EBIT $45.00 $54.00 $64.80 $77.76 $79.70

    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

    FCFF 18.90 23.64 29.09 40.62

    OtherfinancialitemsforSchneiderInc.:

    Estimatedmarketvalueofdebt=$35.0millionCostofdebt=5.0%Sharesoutstanding=20million.

  • Question#19of145 QuestionID:463248

    A)

    B)

    C)

    Question#20of145 QuestionID:463249

    A)

    B)

    C)

    Question#21of145 QuestionID:463250

    A)

    B)

    C)

    Question#22of145 QuestionID:463251

    A)

    GiventheassumptionscontainedinScenario1,thevalueofthefirmismostaccuratelyestimatedas:

    $343million.

    $250million.

    $333million

    Explanation

    UnderthestablegrowthFCFFmodel,thevalueofthefirm=FCFF /(WACCg )=$30million(1.03)/(0.120.03)=$343.33million.

    (LOS36.j)

    InScenario2,theyear0freecashflowtothefirm(FCFF)isclosestto

    $15million.

    $16million.

    $27million.

    Explanation

    FCFF=EBIT(1taxrate)+DepreciationCapitalExpendituresChangeinWorkingCapital=45.0(10.4)+12.018.06.0=15.00.

    (LOS36.d)

    InScenario2,thepresentvalueoftheterminalvalueisclosestto:

    $289million.

    $347million.

    $258million.

    Explanation

    Theterminalvalueis:FCFFforyear4/(WACCgrowthrate)=$40.62/(0.120.02)=$406.22millionintermsofyear3dollars.Thecalculatorinputstosolveforthepresentvalueis:FV=$406.22,N=3,I/Y=12solveforPV.PVis$289.14Million.(LOS36.e)

    (LOS36.e)

    InScenario2,thevalueofthefirmisclosestto:

    $315million.

    1 n

  • B)

    C)

    Question#23of145 QuestionID:463252

    A)

    B)

    C)

    Question#24of145 QuestionID:463253

    A)

    B)

    C)

    Question#25of145 QuestionID:463185

    $346million.

    $321million.

    Explanation

    ThevalueofthefirmisthepresentvalueofYear13plustheterminalvalue.Theterminalvalueis:FCFFforyear4/(WACCgrowthrate)=$40.62/(0.120.02)=$406.22millionintermsofyear3dollars.ThecalculatorinputstosolveNPVforthevalueofthefirmis:CF0=$0,CF1=$18.90,CF2=$23.64,CF3=$29.09+$406.22=$435.31,I=12.NPV=$345.57million.

    (LOS36.d)

    ThecostofequityforSchneiderInc.isclosestto:

    13.0%.

    5.8%.

    11.3%

    Explanation

    TheweightedaveragecostofcapitalformulaisWACC=w r (1t)+w r .Theweightofdebtis10.0%theweightofequitymustbe90.0%.

    0.12=0.100.05(10.40)+0.90r 0.1200.003=0.90r 0.117/0.9=r r =13.0%

    (LOS36.j)

    ThemarketvalueofScheiderInc.'sstockis:

    $17.50pershare.

    $15.75pershare

    $31.50pershare.

    Explanation

    Theestimatedmarketvalueofdebtis$35million,whichrepresents10.0%ofthevalueofthefirm.Theother90.0%isthevalueofequityor$315million.$315million/20millionshares=$15.75pershare.

    (LOS36.j)

    Ananalystisperforminganequityvaluationforaminorityequitypositioninadividendpayingmultinational.Theappropriatemodelforthisanalysisismostlikely:

    d d e e

    e

    e

    e

    e

  • A)

    B)

    C)

    Question#26of145 QuestionID:463217

    A)

    B)

    C)

    Questions#2732of145

    FCFEapproach.

    TheDividendDiscountapproach.

    FCFFapproach.

    Explanation

    Thedividenddiscountmodelismostappropriateforvaluingaminorityequitypositioninadividendpayingcompany.Thefreecashflowapproachlookstothesourceofdividendsfromtheperspectiveofanownerthathascontrolratherthandirectlyatdividends.

    Anincreaseinfinancialleveragewillcausefreecashflowtoequity(FCFE)to:

    increaseintheyeartheborrowingoccurred.

    decreaseintheyeartheborrowingoccurred.

    decreaseorincrease,dependingonitscircumstances.

    Explanation

    Anincreaseinfinancialleveragewillincreasenetborrowingand,hence,increaseFCFEintheyeartheborrowingoccurredbecause:

    FCFE=FCFF[interestexpense](1taxrate)+netborrowing.

    BurcarEckhardt,afirmspecializinginvalueinvestments,hasbeenapproachedbythemanagementofOverhaulTrucking,Inc.,toexplorethepossibilityoftakingthefirmprivateviaamanagementbuyout.Overhaul'sstockhasstumbledrecently,inlargepartduetoasuddenincreaseinoilprices.Managementconsidersthisanopportunetimetotakethecompanyprivate.Burcarwouldbeaminorityinvestorinagroupoffriendlybuyers.

    JaimieCarson,CFA,isaprivateequityportfoliomanagerwithBurcar.HehasbeenaskedbyThelmaEckhardt,CFA,oneofthefirm'sfoundingpartners,totakealookatOverhaulandcomeupwithastrategyforvaluingthefirm.AfteranalyzingOverhaul'sfinancialstatementsasofthemostrecentfiscalyearend(presentedbelow),hedeterminesthatavaluationusingFreeCashFlowtoEquity(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.Considerablyhigherthantheindustryaverage,Eckhardtworriesthatthefirm'sheavyleverageposesarisktoequityinvestors.OverhaulTruckingusesaweightedaveragecostofcapitalof12%forcapitalbudgeting,andEckhardtwondersifthat'srealistic.

    EckhardtasksCarsontodoavaluationofOverhaulinahighgrowthscenariotoseeifoptimisticestimatesofthefirm'sneartermgrowthratecanjustifytherequiredreturntoequity.Forthehighgrowthscenario,sheaskshimtostartwithhis2006estimateofFCFE,growitat30%peryearforthreeyearsandthendecreasethegrowthrateinFCFEinequalincrementsforanotherthreeyearsuntilithitsthelongrungrowthrateof3%in2012.EckhardttellsCarsonthatthereturnstoequityBurcarEckhardtwouldrequireare20%untilthecompletionofthehighgrowthphase,15%duringthethreeyearsofdeclininggrowth,and10percentthereafter.EckhardtwantstoknowwhatBurcarcouldaffordtopayfora15%stakeinOverhaulinthishighgrowthscenario.

    CarsonassemblesafewspreadsheetsandtellsEckhardt,"Wecouldmakeabidofjustunder$16millionforthestakeinOverhaulifthehighgrowthscenarioplaysout."Eckhardtworries,though,thatthevalueoftheirbidisextremelysensitivetotheassumptionforterminalgrowth,sinceinthatscenario,theterminalvalueofthefirmaccountsforslightlymorethantwothirdsofthetotalvalue.

    Carsonagrees,andproposesdoingavaluationundera"sustainedgrowth"scenario.HisestimatesshowOverhaulgrowingFCFEbythefollowingamounts:

    2007 2008 2009 2010 2011

    GrowthinFCFE 40.0% 15.7% 8.6% 9.1% 8.3%

  • Question#27of145 QuestionID:463300

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    Question#28of145 QuestionID:463301

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    Question#29of145 QuestionID:463302

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    Inthisscenario,hewouldprojectsustainedgrowthof6%peryearin2012andbeyond.Withthemorestablegrowthpatternincashflow,EckhardtandCarsonagreethattherequiredreturntoequitycouldbecuttoamoremoderate12%.

    CarsonalsodecidestotryvaluingthefirmonFreeCashFlowtotheFirm(FCFF)usingthissame12%requiredreturn.Usingasinglestagemodelontheestimated2006figurespresentedinthefinancialstatementsabove,hecomesupwithavaluationof$1.08billion.

    WhichofthefollowingisoneofthedifferencesbetweenFCFEandFCFF?FCFFdoesnotdeduct:

    workingcapitalinvestment.

    operatingexpenses.

    interestpaymentstobondholders.

    Explanation

    FCFFincludesthecashavailabletoallofthefirm'sinvestors,includingbondholders.Therefore,interestpaymentstobondholdersarenotremovedfromrevenuestoderiveFCFF.FCFEisFCFFminusinterestpaymentstobondholdersplusnetborrowingsfrombondholders.(StudySession10,LOS30.a)

    WhichofthefollowingistheleastlikelyreasonforCarson'sdecisiontouseFCFEinvaluingOverhaulratherthanFCFF?

    Overhaul'scapitalstructureisstable.

    FCFEisaneasierandmorestraightforwardcalculationthanFCFF.

    Overhaul'sdebtratioissignificantlyhigherthantheindustryaverage.

    Explanation

    ThedifferencebetweenFCFFandFCFEisrelatedtocapitalstructureandresultinginterestexpense.Whenthecompany'scapitalstructureisrelativelystable,FCFEiseasierandmorestraightforwardtouse.FCFFisgenerallythebestchoicewhenFCFEisnegativeorthefirmishighlyleveraged.ThefactthatOverhaul'sdebtratioissignificantlyhigherthantheindustryaveragewouldargueagainsttheuseofFCFE.Hence,thisistheleastlikelyreasontofavorFCFE.(StudySession10,LOS30.a)

    AssumingthatCarsonisusingMay1,2005ashisdateofvaluation,whatistheestimatedvalueofthefirm'sequityunderthescenariomostsuitedtousingthetwostageFCFEmethod?

    $129.5million.

    $173.3million.

    $125.2million.

    Explanation

    The"sustainedgrowth"scenarioistheonlyscenariosuitableforusingthetwostagemethod,inpartbecausethe"highgrowth"scenariousesthreedifferentrequiredratesofreturn.

  • Question#30of145 QuestionID:463303

    A)

    B)

    C)

    First,weneedtocalculateestimatedFCFEin2006.SincetherewerenosalesofPPE,wecancalculateFCInvasthechangeinGrossPPE.

    FCFE=NI+NCCFCInvWCInv+NetBorrowing=16.9+80(480400)[(5570)(5050)]+(113.1140)=16.9+8080+1526.9=$5millionin2006

    HavingcalculatedFCFEin2006,wecancalculateFCFEfor2007through2011usingthegrowthratesprovided:

    2007 2008 2009 2010 2011

    GrowthinFCFE 40.0% 15.7% 8.6% 9.1% 8.3%

    Impliedlevelof

    FCFE

    (inmillions)

    $7.0 $8.1 $8.8 $9.6 $10.4

    NowthatweknowFCFE,wecandiscountfutureFCFEbacktothepresentatthecostofequity.

    Inthefirststageofthetwostagemodel,wedeterminetheterminalvalueatthestartoftheconstantgrowthperiodasfollows:

    TerminalValue=(10.41.06)/(0.120.06)=$183.733million.

    Inthesecondstage,wediscountFCFEforthefirstsixyearsandtheterminalvaluetothepresent.

    EquityValue=[5.0/(1.12) ]+[7.0/(1.12) ]+[8.1/(1.12) ]+[8.8/(1.12) ]+[9.6/(1.12) ]+[(10.4+183.7333)/(1.12) ]EquityValue=4.46+5.58+5.77+5.59+5.45+98.35EquityValue=$125.20million

    (StudySession12,LOS36.j)

    WhatistheexpectedgrowthrateinFCFFthatCarsonmusthaveusedtogeneratehisvaluationof$1.08billion?

    5%.

    7%.

    12%.

    Explanation

    SinceFirmValue=FCFF /(WACCg),wefirstneedtodetermineFCFF ,whichisFCFFin2006:FCFF=NI+NCC+[Int(1taxrate)]FCInvWCInv=16.9+80+[34(10.35)](480400)[(5570)(5050)]=16.9+80+22.180(15)=54FirmValue=FCFF /(WACCg)1080=54/(0.12x)[(1080)(0.12)]1080x=54129.61080x=5475.6=1080x0.07=x

    1 2 3 4 5 6

    1 1

    1

  • Question#31of145 QuestionID:463304

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    Question#32of145 QuestionID:463305

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    C)

    TheexpectedgrowthrateinFCFFthatCarsonmusthaveusedis7%.(StudySession12,LOS36.j)

    IfCarsonhadestimatedFCFEundertheassumptionthatOverhaulTruckingmaintainsatargetdebttoassetratioof36percentfornewinvestmentsinfixedandworkingcapital,whatwouldbehisforecastof2006FCFE?

    $9.6million.

    $26.5million.

    $16.9million.

    Explanation

    FCFE=NI[(1DR)(FCInvDep)][(1DR)WCInv]

    Where:DR=targetdebttoassetratioFCFE=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)

    RegardingthestatementsmadebyCarsonandEckhardtaboutthevalueofOverhaulinthehighgrowthscenario:

    botharecorrect.

    onlyoneiscorrect.

    bothareincorrect.

    Explanation

    Thisisacomplexproblem.Itwouldhelptocreateatable:

    2006(year1)

    2007(year2)

    2008(year3)

    2009(year4)

    2010(year5)

    2011(year6)

    2012(year7)

    GrowthinFCFE(given) n/a 30% 30% 30% 21% 12% 3%ForecastFCFE(calculated) 5.0 6.50 8.45 10.99 13.29 14.89 15.33Requiredreturntoequity(given) 20% 20% 20% 20% 15% 15% 15%

    Totaldiscountfactor(calculated) 1.20 (1.20) (1.20) (1.20) (1.20) (1.15) (1.20) (1.15) (1.20) (1.15)

    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,thetotaldiscountfactorforyear4is(1.20) sothetotaldiscountfactorforyear5,whentheyear5requiredrateofreturndropsfrom20%to15%,becomes(1.20) (1.15).

    Usingthetotaldiscountfactorsfromline4,wecancalculatethepresentvalueofeachyear'scashflowinline5.Forexample,thepresentvalueofyear2010FCFEof$13.29millionwillbe$13.29/[(1.20) (1.15)]or$5.57million.

    2 3 4 4 4 2 4 3

    4

    4

    4

  • Question#33of145 QuestionID:463190

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    Question#34of145 QuestionID:463307

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    B)

    Oncewehavethediscountedcashflowsforeachyear,weneedtocalculatetheterminalvalue.Terminalvaluewillbe:

    TV=(15.33)(1.03)/(0.100.03)

    TV=15.7899/0.07

    TV=$225.57million

    Notethattherequiredrateofreturnusedfortheterminalvalueistherateforthesteadygrowthperiod,whichislowerthanthatusedinthehighgrowthphase(stage)orthedeclininggrowthphase(stagetwo).

    Wenowneedtodiscountterminalvaluebackusingthetotaldiscountfactorfor2012:

    PVofterminalvalue=$225.57million/[(1.20) (1.15) ]

    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=$15.94millionfora15%stakeinthefirm.Sincethisisslightlylessthan$16million,Carson'sstatementiscorrect.Theterminalvaluerepresents($71.53/$106.26)=67.3%ofthefirm'spresentvalue,soEckhardt'sstatementisalsocorrect.(StudySession12,LOS36.j)

    Incomputingfreecashflow,themostsignificantnoncashexpenseisusually:

    depreciation.

    capitalexpenditures.

    deferredtaxes.

    Explanation

    Depreciationisusuallythelargestnoncashexpense.

    Afirmhas:

    Freecashflowtothefirm=$4.0million.

    Weightedaveragecostofcapital=10%.

    Totaldebt=$30.0million.

    Longtermexpectedgrowthrate=5%.

    Valueofthefirm=$50.00pershare.

    Whatwillhappentothevalueofthefirmiftheweightedaveragecostofcapitalincreasesto12%?

    Thevaluewillremainthesame.

    Thevaluewillincrease.

    4 3

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    Question#35of145 QuestionID:463310

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    Question#36of145 QuestionID:463202

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    Question#37of145 QuestionID:463311

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    Thevaluewilldecrease.

    Explanation

    Everythingelsebeingconstant,anincreaseintherelevantrequiredrateofreturnshoulddecreasethevalueofthefirm.

    Infiveyears,afirmisexpectedtobeoperatinginastageofitslifecyclewhereinitsexpectedgrowthrateis5%,indefinitelyitsrequired

    rateofreturnonequityis11%itsweightedaveragecostofcapitalis9%andthefreecashflowtoequityinyear6willbe$5.25per

    share.Whatisitsprojectedterminalvalueattheendofyear5?

    $131.25.

    $51.93.

    $87.50.

    Explanation

    Terminalvalue=FCFE/(kg)=$5.25/(0.110.05)=$87.50

    Inforecastingfreecashflowsitiscommontoassumethatinvestmentinworkingcapital:

    isgreaterthanfixedcapitalinvestmentduringagrowthphase.

    willbefinancedusingthetargetdebtratio.

    willequalfixedcapitalinvestment.

    Explanation

    Itisusuallyassumedthattheinvestmentinworkingcapitalwillbefinancedconsistentwiththetargetdebtratio.

    Terminalvalueinmultistagefreecashflowvaluationmodelsisoftencalculatedasthepresentvalueof:

    atwostagevaluationmodel'sprice.

    freecashflowdividedbythegrowthrate.

    aconstantgrowthmodel'spriceasofthebeginningofthelaststage.

    Explanation

    Terminalvaluesareusuallycalculatedasthepresentvalueofthepriceproducedbyaconstantgrowthmodelasofthebeginningofthe

    laststage.

  • Questions#3843of145

    Question#38of145 QuestionID:463260

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    Question#39of145 QuestionID:463261

    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%.

    Thefreecashflowtothefirm(FCFF)forthecurrentyearisclosestto:

    $3.57million.

    $2.39million.

    $2.31million.

    Explanation

    TheFCFFforthecurrentyearis[$6.00m(10.40)]+$0.63m$1.25m$0.59m=$2.39m.

    (LOS36.d)

    TheappropriatediscountratetoapplyinvaluingBICusingFCFFisclosestto:

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    Question#40of145 QuestionID:463262

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    Question#41of145 QuestionID:463263

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    Question#42of145 QuestionID:463264

    12.1%.

    16.0%.

    13.8%.

    Explanation

    Theappropriatediscountratetouseistheweightedaveragecostofcapital(WACC),andthisisWACC=(0.600.16)+[0.400.105

    (10.40)]=12.12%.

    (LOS36.j)

    Theestimatedvalueofthefirmisclosestto:

    $38million.

    $47million.

    $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)

    Iftheestimatedvalueofthefirmis$50.0million,thevaluepershareofBICstockshouldbeclosestto:

    $60.

    $28.

    $30.

    Explanation

    Equityvalue=Firmvaluemarketvalueofdebt$50million$20million=$30million:

    $30,000,000/500,000=$60.00pershare.

    (LOS36.j)

    Iftheestimatedvalueofthefreecashtothefirm(FCFF)foryear0is$2.4million,thevaluepershareofBICstock,basedonthestablegrowthmodel,isclosestto:

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    Question#43of145 QuestionID:463265

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    Question#44of145 QuestionID:463174

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    C)

    $61

    $55

    $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)

    ThecurrentmarketpriceofBICis$62.50pershare,andthecurrentyear'sFCFEis$1.75million.Usingatwostagegrowthmodeltofindtheestimatedthefirm'svalue,thecurrentmarketpriceBICismostaccuratelydescribedas:

    overvalued.

    fairlyvalued.

    undervalued.

    Explanation

    FCFE=FCFFInterestexpense(1T)+Newborrowing.

    Year 0 1 2 3 4Growthrate 25.0% 25.0% 25.0% 6.0%FCFEinmil$

    $1.750 $2.188 $2.734 $3.418 $3.623

    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$62.50pershare,asourestimatedvalueof$58.64suggeststhatthemarketpriceistoohigh.

    (LOS36.m)

    Thedifferencebetweenfreecashflowtoequity(FCFE)andfreecashflowtothefirm(FCFF)is:

    beforetaxinterestandnetborrowing.

    earningsbeforeinterestandtaxes(EBIT)lesstaxes.

    aftertaxinterestandnetborrowing.

    Explanation

  • Question#45of145 QuestionID:463222

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    Question#46of145 QuestionID:463230

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    Question#47of145 QuestionID:463258

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    B)

    C)

    FCFE=FCFF[interestexpense](1taxrate)+netborrowing.

    Therepurchaseof20%ofafirm'soutstandingcommonshareswillcausefreecashflowtothefirm(FCFF)to:

    decrease.

    remainthesame.

    increase.

    Explanation

    Sharerepurchasesareauseoffreecashflows,notasource.FCFFiscashflowthatisavailabletoallcapitalsuppliers.Noticethe

    conspicuousabsenceofrepurchasesinthefollowing:FCFF=CFO+Int(1taxrate)FCInv.

    Whichofthefollowingfreecashflowtothefirm(FCFF)modelsismostsuitedtoanalyzefirmsthataregrowingatafasterratethanthe

    overalleconomy?

    HighgrowthFCFFmodel.

    NogrowthFCFFmodel.

    TwostageFCFFmodel.

    Explanation

    ThetwostageFCFFmodelismostsuitedforanalyzingfirmsgrowingataratefasterthantheoveralleconomy.Thetwostagemodel

    assumesahighrateofgrowthforaninitialperiod,followedbyanimmediatejumptoaconstant,stablegrowthrate.

    ThevalueofstockunderthetwostageFCFEmodelwillbeequalto:

    presentvalue(PV)ofFCFEduringtheextraordinarygrowthandtransitionalperiodsplusthePVofterminalvalue.

    presentvalue(PV)ofFCFEduringtheextraordinarygrowthperiodplustheterminalvalue.

    presentvalue(PV)ofFCFEduringtheextraordinarygrowthperiodplusthePVofterminalvalue.

    Explanation

    ThevalueofstockunderthetwostageFCFEmodelwillbeequaltothepresentvalueofFCFEduringtheextraordinarygrowthperiodplusthepresentvalueoftheterminalvalueattheendofthisperiod.

  • Question#48of145 QuestionID:463308

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    Question#49of145 QuestionID:463236

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    Question#50of145 QuestionID:463193

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    B)

    C)

    Afirmhas:

    Freecashflowtoequity=$4.0million.

    Costofequity=12%.

    Longtermexpectedgrowthrate=5%.

    Valueofequitypershare=$57.14pershare.

    Whatwillhappentothevalueofthefirmiffreecashflowtoequitydecreasesto$3.2million?

    Thereisinsufficientinformationtotell.

    Thevaluewilldecrease.

    Thevaluewillincrease.

    Explanation

    Everythingelsebeingconstant,adecreaseinfreecashflowtoequityshoulddecreasethevalueofthefirm.

    Whichofthefollowingfreecashflowtoequity(FCFE)modelsismostsuitedtoanalyzefirmsinanindustrywithsignificantbarriersto

    entry?

    StableGrowthFCFEModel.

    TwostageFCFEModel.

    FCFEPerpetuityModel.

    Explanation

    ThetwostageFCFEmodelismostsuitedforanalyzingfirmsinhighgrowththatwillmaintainthatgrowthforaspecificperiod,suchas

    firmswithpatentsorfirmsinanindustrywithsignificantbarrierstoentry.

    WhichofthefollowingitemsisNOTsubtractedfromthenetincometocalculatefreecashflowtoequity(FCFE)?

    increaseinaccountsreceivable.

    Interestpaymentstobondholders.

    Increaseinfixedassets.

    Explanation

    Interestpaymentstobondholdersareincludedintheincomestatementandarealreadysubtractedtocalculatenetincome.

  • Question#51of145 QuestionID:463200

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    Question#52of145 QuestionID:463277

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    Question#53of145 QuestionID:463309

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    C)

    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?

    $5.90.

    $7.50.

    $2.90.

    Explanation

    FCFF=EPS+netnoncashcharges+aftertaxinterestFCInvWCInvFCFF=$4.00+3.00+$2.40$2.001.50=$5.90

    Afirm'sfreecashflowtoequity(FCFE)inthemostrecentyearis$50Mandisexpectedtogrowat5%peryearforever.Ifits

    shareholdersrequireareturnof12%,thevalueofthefirm'sequityusingthesinglestageFCFEmodelis:

    $714M.

    $417M.

    $750M.

    Explanation

    Thevalueofthefirm'sequityis:$50M1.05/(0.120.05)=$750M

    InthetwostageFCFEmodel,therequiredrateofreturnforcalculatingterminalvalueshouldbe:

    lowerthantherequiredrateofreturnusedforthehighgrowthphase.

    higherthantherequiredrateofreturnusedforthehighgrowthphase.

    equaltotheaveragerequiredrateofreturnfortheindustry.

    Explanation

    Inmostcases,therequiredrateofreturnusedtocalculatetheterminalvalueshouldbelowerthantherequiredrateofreturnusedforinitialhighgrowthphase.Duringthestableperiodthefirmislessriskyandtherequiredrateofreturnisthereforelower.

  • Questions#5459of145

    Question#54of145 QuestionID:463286

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    BeachwoodBuildersmergedwithCountryPointHomesinDecember31,1992.Bothcompanieswerebuildersofmidscaleandluxuryhomesintheirrespectivemarkets.In2004,becauseoftaxconsiderationsandtheneedtosegmentthebusinessesbetweenmidscaleandluxuryhomes,BeachwooddecidedtospinoffCountryPoint,itsluxuryhomesubsidiary,toitscommonshareholders.BeachwoodretainedBernheimSecuritiestovaluethespinoffofCountryPointasofDecember31,2004.

    Whenthebooksclosedon2004,Beachwoodhad$140millionindebtoutstandingduein2012atacouponrateof8%,aspreadof2%abovethecurrentriskfreerate.Beachwoodalsohad5millioncommonsharesoutstanding.Itpaysnodividends,hasnopreferredshareholders,andfacesataxrateof30%.Whenvaluingcommonstock,Bernhiem'svaluationmodelsutilizeamarketriskpremiumof11%.

    ThecommonequityallocatedtoCountryPointforthespinoffwas$55.6millionasofDecember31,2004.TherewasnolongtermdebtallocatedfromBeachwood.

    TheManagingDirectorinchargeofBernheim'sconstructiongroup,DenzelJohnson,ispreppingforthevaluationpresentationforBeachwood'sboardwithCaraNguyen,oneofthefirm'sassociates.NguyentellsJohnsonthatBernheimestimatedCountryPoint'snetincomeat$10millionin2004,growing$5millionperyearthrough2008.BasedonNguyen'scalculations,CountryPointwillbeworth$223.7millionin2008.NguyendecidedtouseacostofequityforCountryPointinthevaluationequaltoitsreturnonequityattheendof2004(roundedtothenearestpercentagepoint).

    NguyenalsogivesJohnsonthetablesheobtainedfromBeachwoodprojectingdepreciation(theonlynoncashcharge)andcapitalexpenditures:

    $(inmillions) 2004 2005 2006 2007 2008

    Depreciation 5 6 5 6 5

    CapitalExpenditures 7 8 9 10 12

    Lookingatthenumbers,JohnsontellsNguyen,"CountryPoint'sfreecashflow(FCF)willbe$25millionin2006."Nguyenadds,"That'sFCFtotheFirm(FCFF).FCFtoEquity(FCFE)willbelower."

    RegardingthestatementsbyJohnsonandNguyenaboutFCFin2006:

    onlyNguyenisincorrect.

    bothareincorrect.

    onlyJohnsonisincorrect.

    Explanation

    ToestimateFCF,wecanconstructthefollowingtableusingthetablegivenandtheinformationaboutgrowthinnetincome:

    $(inmillions) 2004 2005 2006 2007 2008

    NetIncome 10 15 20 25 30

    Plus:Depreciation 5 6 5 6 5

    Less:CapitalExpenditures 7 8 9 10 12

  • Question#55of145 QuestionID:463287

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    B)

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    Question#56of145 QuestionID:463288

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    B)

    C)

    Question#57of145 QuestionID:463289

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    B)

    C)

    FreeCashFlow 8 13 16 21 23

    Theestimatedfreecashflowfor2006is$16million.Johnson'sstatementisincorrect.SincenoneofBeachwood'sdebtisallocatedtoCountryPoint,allthefinancingisintheformofequity,soFCFFandFCFEareequal.Nguyen'sstatementisalsoincorrect.(StudySession12,LOS36.j)

    IfFCInvequalsFixedCapitalInvestmentandWCInvequalsWorkingCapitalInvestment,whichstatementaboutFCFanditscomponentsisleastaccurate?

    WCInvisthechangeintheworkingcapitalaccounts,excludingcashandshorttermborrowings.

    FCFF=(EBITDA(1taxrate))+(Depreciationtaxrate)FCInvWCInv.

    FCFE=(EBIT(1taxrate))+DepreciationFCInvWCInv.

    Explanation

    Thecorrectversionofthisequationis:FCFF=(EBIT(1taxrate))+DepreciationFCInvWCInv(StudySession12,LOS36.j)

    WhatisthecostofcapitalthatNguyenusedforhervaluationofCountryPoint?

    17%.

    15%.

    18%.

    Explanation

    SincethereisnodebtallocatedtoCountryPoint,thecostofcapitalwillequalthecostofequity.NguyensaidthatsheusedacostofequityequaltoCountryPoint'sReturnonEquity(ROE)atyearend,roundedtothenearestpercentagepoint.Sincethenetincomeattheendof2004was$10millionandtheallocatedcommonequitywas$55.6million,thereturnofequityis(10million/55.6million)=18%.(StudySession18,LOS62.c)

    GivenNguyen'sestimateofCountryPoint'sterminalvaluein2008,whatisthegrowthassumptionshemusthaveusedforfreecashflowafter2008?

    3%.

    7%.

    9%.

    Explanation

    Weknowtheterminalvaluein2008is$223.7million.Wecancalculatethefreecashflowin2008tobe$23million(=$30millionnetincome+$5milliondepreciation$12millioncapitalexpenditures).(Seethetableinquestion1).Thus,wecansolvefortheestimatedgrowthrate:

  • Question#58of145 QuestionID:463290

    A)

    B)

    C)

    Question#59of145 QuestionID:463291

    A)

    B)

    C)

    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)

    ThevalueofbetaforCountryPointis:

    1.09.

    1.00.

    1.27.

    Explanation

    Theriskfreerateis(8%2%)=6%.Wearetoldthatthemarketriskpremiumis11%,andwecalculatedthecostofequity(requiredreturn)tobe(10million/55.6million=)18%.Sinceweknowtheriskfreerate,themarketriskpremium,andthediscountrate,wecanusethecapitalassetpricingmodeltosolveforbeta:

    Requiredrateofreturn=0.18=0.06+(b0.11)

    0.180.06=b0.11

    0.12=b0.11

    b=1.09

    (StudySession12,LOS36.c)

    WhatistheestimatedvalueofCountryPointinaproposedspinoff?

    $162.6million.

    $178.3million.

    $144.5million.

    Explanation

    Usingthediscountedcashflowapproachonthelevelsofcashflowwecalculated(seethetableinquestion1):

    Firmvalue=($13/1.18 )+($16/1.18 )+($21/1.18 )+($23/1.18 )+($223.7/1.18 )

    =$11.0+$11.5+$12.8+$11.9+$115.4

    =$162.6million

    (StudySession12,LOS36.c)

    1 2 3 4 4

  • Question#60of145 QuestionID:463212

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    B)

    C)

    Question#61of145 QuestionID:463256

    A)

    B)

    C)

    Question#62of145 QuestionID:463267

    Thedifferencebetweenthevalueestimateproducedbythedividenddiscountmodel(DDM)andtheoneproducedbythefreecashflowto

    equity(FCFE)modelcanbeaccountedforbywhichofthefollowing?

    Differentsalesforecast.

    Thevalueincontrollingthefirm'sdividendpolicy.

    Differentestimatesofmodelrisk.

    Explanation

    ThedifferencebetweenthevalueestimateproducedbytheDDMandtheoneproducedbytheFCFEmodelcanbeinterpretedasthe

    valueofcontrollingthefirm'sdividendpolicy.

    Afirm'sfreecashflowtothefirm(FCFF)inthemostrecentyearis$80Mandisexpectedtogrowat3%peryearforever.Ifthefirmhas

    $100Mindebtfinancinganditsweightedaveragecostofcapitalis10%.Thevalueofthefirm'sequityusingthesinglestageFCFFmodel

    is:

    $1,177M.

    $1,043M.

    $1,077M.

    Explanation

    Thevalueofthefirm'sequityisequaltothevalueofthefirmminusthevalueofthedebt.Firmvalue=$80M1.03/(0.100.03)=

    $1,177M,soequityvalueis$1,177M$100M=$1,077M.

    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%.

  • A)

    B)

    C)

    Question#63of145 QuestionID:463237

    A)

    B)

    C)

    Questions#6469of145

    Weightedaveragecostofcapital(WACC)duringstablegrowthstage=12%.

    Targetdebtratio=10%.

    Scenario2FCFFYear0

    (lastyear)Year1 Year2 Year3 Year4

    EBIT $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

    FCFF 5.95 7.06 8.25 11.56

    GiventheassumptionscontainedinScenario2,whatisthevalueofthefirm?

    $81.54.

    $96.92.

    $70.39.

    Explanation

    UsethetwostageFCFFmodeltovaluethefirm.TheTerminalValueofthefirmasofYear3=11.56/(0.120.02)=115.60.Thevalue=

    5.95/(1.20)+7.06/(1.20) +(8.25+115.62)/(1.20) =81.54.

    WhichofthefollowingstatementsregardingtheFCFFmodelsismostaccurate?ThetwostageFCFFmodelismoreusefulthanthe

    stablegrowthFCFFmodelwhenthefirmisgrowingatarate:

    significantlyhigherthanthatoftheoveralleconomy.

    notsignificantlyhigherthanthatoftheoveralleconomy.

    significantlylowerthanthatoftheoveralleconomy.

    Explanation

    ThetwostageFCFFmodelismoreusefulinvaluingafirmthatisgrowingataratesignificantlyhigherthantheoveralleconomy.Since

    thiscannotpersistindefinitely,growthwilleventuallyslowtoastablegrowthrateconsistentwiththatoftheeconomy.

    ThefollowinginformationwascollectedfromthefinancialstatementsofHillerGmbH,aGermanconsultingcompany,fortheyearending

    December31,2013:

    Earningspershare=4.50.

    CapitalExpenditurespershare=3.00.

    Depreciationpershare=2.75.

    Increaseinworkingcapitalpershare=0.75.

    2 3

  • Question#64of145 QuestionID:463206

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    B)

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    Question#65of145 QuestionID:463207

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    B)

    C)

    Question#66of145 QuestionID:463208

    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#2estimatesFCFEpershareas3.85.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%

    TheFCFEbasedonAnalyst#1'sestimatesforthebaseyearisclosestto:

    3.80.

    3.00.

    4.85.

    Explanation

    BaseyearFCFE=EPS(capitalexpendituresdepreciation)(1debtratio)increaseinworkingcapital(1debtratio)=4.50

    (3.002.75)(10.30)0.75(10.30)=3.80.(LOS36.d)

    UsingthestablegrowthFCFEmodelassuggestedbyAnalyst#1,thevalueofHillerstockisclosestto:

    51.58.

    54.29.

    57.00.

    Explanation

    Valuepershare=(3.801.05)/(0.120.05)=57.00.(LOS36.j)

  • A)

    B)

    C)

    Question#67of145 QuestionID:463209

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    B)

    C)

    Question#68of145 QuestionID:463210

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    B)

    C)

    Question#69of145 QuestionID:463211

    BasedonAnalyst#2'sestimates,thesumoftheterminalvalueplustheFCFEforyear6isclosestto:

    82.40.

    60.70.

    75.80.

    Explanation

    EstimatesforthefutureFCFEbasedonsuppliedgrowthratesare:

    Year 0 1 2 3 4 5 6 7

    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

    Thenominalcashflowforyear6is75.76+6.62=82.38,whichistheterminalcashflowplustheFCFEvaluefortheyear.(LOS36.e)

    BasedonAnalyst#2'sestimates,thevalueofHillerstockisclosestto:

    59.70.

    57.00.

    60.70.

    Explanation

    Year 0 1 2 3 4 5 6 7

    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

    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)

    TheappropriatediscountrateforvaluingHilleronafreecashflowbasisisclosestto:

    12.00%.

    6.54%.

    9.66%.

    Explanation

    Theappropriatediscountrateistheweightedaveragecostofcapital.Theformulais:WACC=w r (1taxrate)+w r =(0.30)

    (0.06)(10.30)+(0.70)(0.12)=0.0966or9.66%.(LOS36.j)

    IfHiller'stotalfreecashflowtoequityis380millionandthegrowthrateofthefirmis3.5%,thevalueofHiller(Firm)usingthestable

    d d e e

  • A)

    B)

    C)

    Question#70of145 QuestionID:463266

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    B)

    C)

    Question#71of145 QuestionID:463257

    growthmodelisclosestto:

    6.7billion.

    8.9billion.

    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)

    Usingthestablegrowthfreecashflowtothefirm(FCFF)model,whatisthevalueofQualityBuildersundertheassumptionscontainedin

    thetablebelow?

    QualityBuilders

    FreeCashFlowtotheFirm

    Year0

    EBIT $500

    Depreciation $200

    CapitalSpending $300

    WorkingCapitalAdditions $30

    TaxRate 40%

    AssumedConstantGrowthRatein

    FreeCashFlow5%

    WeightedaverageCostofCapital 11%

    $2,975.00.

    $2,833.33.

    $6,475.00.

    Explanation

    ThestablegrowthFCFFmodelassumesthatFCFFgrowsataconstantrateforever.FCFFinYear0isequaltoEBIT(1taxrate)+

    DepreciationCapitalSpendingWorkingCapitalAdditions=500(10.4)+20030030=170.TheFirmValue=FCFF /(rg )=

    170(1.05)/(0.110.05)=$2,975.1 n

  • A)

    B)

    C)

    Question#72of145 QuestionID:463173

    A)

    B)

    C)

    Question#73of145 QuestionID:463204

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    B)

    C)

    Questions#7479of145

    IndustrialLightcurrentlyhas:

    Freecashflowtoequity=$4.0million.

    Costofequity=12%.

    Weightedaveragecostofcapital=10%.

    Totaldebt=$30.0million.

    Longtermexpectedgrowthrate=5%.

    Whatisthevalueofequity?

    $57,142,857.

    $60,000,000.

    $27,142,857.

    Explanation

    Thevalueofequityis[($4,000,000)(1.05)/(0.120.05)]=$60,000,000.

    WhenusingthetwostageFCFEmodel,ifincreasesinworkingcapitalappeartoohightheanalystshould:

    switchtoathreestagemodel.

    normalizethemtobeequaltozero.

    usechangesthatarebaseduponaworkingcapitalratiothatisclosertotheindustryaverage.

    Explanation

    Thebestsolutionistousechangesthatarebaseduponaworkingcapitalratiothatapproximatestheindustryaverage.Theproblemwill

    notbeeliminatedbyswitchingtoathreestageFCFEmodel.

    Acommonapproachtoforecastingfreecashflowsisto:

    calculatehistoricalfreecashflowandapplyanexpectedgrowthrate.

    projectearningsbeforeinterestandtaxes(EBIT)andexpectedcapitalexpenditures.

    projectnetincomeandexpectedcapitalexpenditures.

    Explanation

    Historicalfreecashflowsareoftenusedforforecasting.

    StarshahIndustriescompetesinahighgrowth,emergingtechnologysectorthatisfacingincreasingcompetitivepressures.Sofar,the

  • Question#74of145 QuestionID:463269

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    B)

    C)

    Question#75of145 QuestionID:463270

    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.

    WhichofthefollowingFCFEmodelsisbestsuitedtoanalyzingTPX?

    TwostageFCFEmodel.

    StablegrowthFCFEmodel.

    ThreestageFCFEmodel.

    Explanation

    ThetwostageFCFEmodelismostsuitedtoanalyzingTPXbecausewehavespecificforecastsforthefirstseveralyearsandthena

    stablegrowthpatternintotheindefinitefuture.(StudySession12,LOS36.i)

  • A)

    B)

    C)

    Question#76of145 QuestionID:463271

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    B)

    C)

    Question#77of145 QuestionID:463272

    TheFCFEforStarshahattheendofthetransitionperiodin2011isclosestto:

    $21.89.

    $20.62.

    $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)

    RegardingdiStefano'sandSimmons'statementsabouttheterminalvalueofStarshahstockin2011:

    botharecorrect.

    onlySimmonsiscorrect.

    onlydiStefanoiscorrect.

    Explanation

    Starshahhitsthestablegrowthphasein2012.Atthatpoint,

    TerminalFirmValue =(FCFEinyear2012)/(requiredrateofreturn&8722growthrate)

    =$21.89(1.05)/(0.100.05)=$22.98pershare/0.05

    =$460pershare.DiStefano'sstatementiscorrect.

    TerminalFirmValue =(FCFEinyear2012)/(requiredrateofreturn&8722growthrate)=$21.89(1.05)/(0.150.05)

    =$22.98pershare/0.10=$230pershare.Simmons'statementisalsocorrect.

    (StudySession12,LOS36.j)

    AssumingSimmonsisrightthattherequiredreturnonStarshahequityrisesto15%in2012andbeyond,whatisthevalueofStarshah

    2011

    2011

  • A)

    B)

    C)

    Question#78of145 QuestionID:463273

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    B)

    C)

    Question#79of145 QuestionID:463274

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    B)

    C)

    stockattheendof2004?

    $63.71.

    $117.49.

    $111.35.

    Explanation

    Inordertocalculatethefirmvalue,weneedtoknowthediscountratethatappliesovereachperiod.Sincethediscountratechanges,we

    cansimplifythearithmeticbyconstructingatableofdiscountfactorsusing25%foreachofthefirsttwoyearsand15%foreachofthe

    followingfiveyears:

    2005 2006 2007 2008 2009 2010 2011

    Discountfactor 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)

    WhatisthemaximumamountthatStarshahwouldbewillingtopayforTPX(inmillions)?

    $5.102.

    $5.874.

    $6.941.

    Explanation

    FirmValue=[500/(1.20) ]+[600/(1.20) ]+[700/(1.20) ]+[(700)(1.03)/(0.12&87220.03)/(1.20) ]=$5,874.

    ThemostthatStarshahcouldpayforTPXandstillmeetitsrequiredreturntargetsis$5.874million.(StudySession12,LOS39.j)

    WhichofthefollowingFCFEmodelsisbestsuitedtoanalyzingStarshahIndustries?

    ThreestageFCFEmodel.

    TwostageFCFEmodel.

    StablegrowthFCFEmodel.

    Explanation

    ThethreestageFCFEmodelismostsuitedtoanalyzefirmsinhighgrowthindustriesthatwillfaceincreasingcompetitivepressuresover

    time,sincethosecompetitivepressureswillleadtoagradualdeclineinthefirm'sgrowthrate(secondstage)toastablelevel(third

    1 2 3 3

  • Question#80of145 QuestionID:463219

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    B)

    C)

    Question#81of145 QuestionID:463201

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    B)

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    Question#82of145 QuestionID:463312

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    B)

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    Question#83of145 QuestionID:463231

    stage).(StudySession12,LOS36.i)

    Currently,afirmhasnooutstandingdebt.Ifthefirmwouldaddasmallamountofleveragetoitsbalancesheet,whatshouldbethe

    impactonthefirm'svalue?Therewouldbe:

    nochangeinfirmvalue.

    adecreaseinvalueduetohigherinterestexpense.

    anincreaseinvalueduetointeresttaxshields.

    Explanation

    Theamountoffinancialleverageusedbyafirmwillaffectitsvalue.Forsmallamountsofleverage,theadditionalbankruptcyriskwillbe

    low,andwillbemorethanoffsetbytheadditionalvalueofinteresttaxshields.

    Inforecastingfreecashflowsitiscommontoassumethat:

    thefirmhasnononcashexpenses.

    historicalandfuturefreecashflowwillbethesame.

    thefirmadherestoatargetcapitalstructure.

    Explanation

    Atargetdebtratioisusuallyassumedtoremainconstant.Historicalcashflowsareoftenprojectedforwardwithagrowthrate.

    Terminalvalueinamultistagefreecashflowtoequity(FCFE)valuationmodelisoftencalculatedasthepresentvalueof:

    FCFEdividedbythetotalofrequiredrateonequityminusgrowth.

    freecashflowdividedbythegrowthrate.

    atwostagevaluationmodel'sprice.

    Explanation

    Terminalvaluesareusuallycalculatedasthepresentvalueofthepriceproducedbyaconstantgrowthmodelasofthebeginningofthe

    laststage,whichisFCFE/(requiredrateonequitygrowth).

    Whichofthefollowingtypesofcompaniesisthetwostagefreecashflowtoequity(FCFE)modelbestsuitedfor?Companies:

  • A)

    B)

    C)

    Question#84of145 QuestionID:463187

    A)

    B)

    C)

    Question#85of145 QuestionID:463176

    A)

    B)

    C)

    Question#86of145 QuestionID:463192

    A)

    B)

    inhighgrowthindustriesthatwillfaceincreasingcompetitivepressuresovertime,

    leadingtoagradualdeclineingrowthtoastablelevel.

    growingataratesimilartoorlessthanthenominalgrowthrateoftheeconomy.

    withpatentsorfirmsinanindustrywithsignificantbarrierstoentry.

    Explanation

    Thetwostagemodelisbestsuitedtoanalyzingfirmsinahighgrowthphasethatwillmaintainthatgrowthforaspecificperiod,suchas

    firmswithpatentsorfirmsinanindustrywithsignificantbarrierstoentry.Companiesgrowingataratesimilartoorlessthanthenominal

    growthrateoftheeconomyarebestsuitedforthesinglestageFCFEModel.Companiesinhighgrowthindustriescorrespondtothethree

    StageFCFEModel.

    Theownershipperspectiveimplicitinthedividendvaluationapproachisof:

    apreferredstockholder.

    acommonstockholder.

    control.

    Explanation

    Dividendsaremostrelevanttothestockholderswhoreceivethemandwhohavelittlecontrolovertheiramount.

    WhatisthemostlikelyreasonthatyougetanextremelylowvaluefromthethreestageFCFEmodel?Capitalexpendituresare

    significantly:

    higherthandepreciationduringthehighgrowthphase.

    higherthandepreciationinthestablegrowthphase.

    lessthandepreciationduringthehighgrowthphase.

    Explanation

    Ifcapitalexpendituresestimatesaresignificantlyhigherthandepreciationforthestablegrowthperiod,thenthethreestageFCFEmodel

    mightresultinanextremelylowvalue.Onepossiblesolutionfortheproblemistogrowthecapitalexpendituresmoreslowlythan

    deprecationinthetransitionperiodtonarrowthedifference.Anotheristoassumethatcapitalexpendituresanddepreciationwilloffset

    whengrowthnormalizes.

    Freecashflowtothefirmisequaltocashflowfromoperationsminusfixedcapitalinvestment:

    minusaftertaxinterestexpense.

    minuspretaxinterestexpense.

  • C)

    Question#87of145 QuestionID:463242

    A)

    B)

    C)

    Question#88of145 QuestionID:463167

    A)

    B)

    C)

    Question#89of145 QuestionID:463203

    plusaftertaxinterestexpense.

    Explanation

    Freecashflowtothefirmisequaltocashflowfromoperationsminusfixedcapitalinvestmentplusaftertaxinterestexpense.

    WhichofthefollowingtypesofcompanyistheEModel,athreestagefreecashflowtoequity(FCFE)Model,bestsuitedfor?

    Companies:

    growingataratesimilartoorlessthanthenominalgrowthrateoftheeconomy.

    inhighgrowthindustriesthatwillfaceincreasingcompetitivepressuresovertime,leadingtoa

    gradualdeclineingrowthtoastablelevel.

    withpatentsorfirmsinanindustrywithsignificantbarrierstoentry.

    Explanation

    ThethreestageFCFEmodel,orEModel,ismostsuitedtoanalyzingfirmscurrentlyexperiencinghighgrowththatwillfaceincreasing

    competitivepressuresovertime,leadingtoagradualdeclineingrowthtoastablelevel.Thetwostagemodelisbestsuitedtoanalyzing

    firmsinahighgrowthphasethatwillmaintainthatgrowthforaspecificperiod,suchasfirmswithpatentsorfirmsinanindustrywith

    significantbarrierstoentry.Companiesgrowingataratesimilartoorlessthanthenominalgrowthrateoftheeconomyarebestsuitedfor

    theStableGrowthFCFEModel.Afirmthatpaysoutallofitsearningsasdividendswillhaveagrowthrateofzero(rememberg=RR

    ROE)andwouldnotbevaluedusingthethreestageFCFEmodel.

    Freecashflowtothefirmvaluationuseswhichdiscountrate?

    Aftertaxcostofdebt.

    Costofequity.

    Weightedaveragecostofcapital.

    Explanation

    Freecashflowtothefirmvaluationusestheopportunitycostrelevanttotheoverallfirm,whichistheweightedaveragecostofcapital.

    ThefollowingtableprovidesbackgroundinformationonapersharebasisforTOYInc.intheyear0:

    CurrentInformation: Year0

    Earnings $5.00

    CapitalExpenditures $2.40

    Depreciation $1.80

  • A)

    B)

    C)

    Question#90of145 QuestionID:463235

    A)

    B)

    C)

    Question#91of145 QuestionID:463218

    A)

    B)

    C)

    ChangeinWorkingCapital $1.70

    TOYInc.'stargetdebtratiois30%andhasarequiredrateofreturnof12%.Earnings,capitalexpenditures,depreciation,andworking

    capitalareallexpectedtogrowby5%ayearinthefuture.Assumethatcapitalexpendituresandworkingcapitalarefinancedatthetarget

    debtratio.

    Inyear0,whatisthefreecashflowtoequity(FCFE)forTOYInc.?

    $4.31.

    $3.39.

    $2.70.

    Explanation

    Year0FCFE=Earningspershare(CapitalExpendituresDepreciation)(1DebtRatio)Changeinworkingcapital(1DebtRatio)=

    5.00(2.401.80)(10.3)(1.7)(10.3)=3.39.

    Thestablegrowthfreecashflowtoequity(FCFE)modelisbestsuitedforwhichofthefollowingtypesofcompanies?Companies:

    growingataratesimilarorlessthanthenominalgrowthrateoftheeconomy.

    withsignificantbarrierstoentry.

    withpatentsthatwillnotexpirefor20ormoreyears.

    Explanation

    CompaniesgrowingataratesimilartoorlessthanthenominalgrowthrateoftheeconomyarebestsuitedfortheStableGrowthFCFE

    Model.ThethreestageFCFEmodelismostsuitedtoanalyzingfirmscurrentlyexperiencinghighgrowththatwillfaceincreasing

    competitivepressuresovertime,leadingtoagradualdeclineingrowthtoastablelevel.Thetwostagemodelisbestsuitedtoanalyzing

    firmsinahighgrowthphasethatwillmaintainthatgrowthforaspecificperiod,suchasfirmswithpatentsorfirmsinanindustrywith

    significantbarrierstoentry.

    Optimalcapitalstructureisthemixofdebtandequitythatwillmaximizethevalueofthefirmandminimize:

    weightedaveragecostofcapital(WACC).

    weightedaveragecostofequity.

    interestexpense.

    Explanation

    TheoptimalcapitalstructureisthemixofdebtandequitythatwillmaximizethevalueofthefirmandminimizetheWACC.

  • Question#92of145 QuestionID:463166

    A)

    B)

    C)

    Question#93of145 QuestionID:463195

    A)

    B)

    C)

    Question#94of145 QuestionID:463168

    A)

    InthestablegrowthFCFEmodel,anextremelylowvaluecanresultfromallofthefollowingEXCEPT:

    therequiredrateofreturnistoohighforastablefirm.

    theexpectedgrowthrateistoohighforastablefirm.

    capitalexpendituresaretoohighrelativetodepreciation.

    Explanation

    Iftheexpectedgrowthrateistoohighforastablefirm,thevalueobtainedusingthestablegrowthFCFEmodelwillbeextremelyhigh.

    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:

    $540M.

    $300M.

    $420M.

    Explanation

    Thefreecashflowtothefirmis:

    FCFF=Netincome+(Interestexpense)(1T)Capitalexpenditures+Depreciation

    600M+400M(10.40)800M+500M=540M

    MarkWashington,CFA,usesatwostagefreecashflowtoequity(FCFE)discountmodeltovalueTexasVanLines.Hisanalysisyields

    anextremelylowvalue,whichhebelievesisincorrect.Whichofthefollowingisleastlikelytobeacauseofthissuspectvaluation

    estimate?

    Thecostofequityestimateinthestablegrowthperiodistoohighforastablefirm.

  • B)

    C)

    Question#95of145 QuestionID:463194

    A)

    B)

    C)

    Question#96of145 QuestionID:463213

    A)

    B)

    C)

    Earningsaretemporarilydepressedbecauseofaonetimeextraordinaryaccountingchargein

    themostrecentfiscalyear.

    Theforecastofworkingcapitalasapercentageofrevenuesinthestablegrowthperiodisnot

    largeenoughtomaintainthelongtermsustainablegrowthrate.

    Explanation

    Thelargertheestimateofworkingcapitalasapercentageofrevenues,thelargertheinvestmentinnetworkingcapital,andthelowerthe

    FCFEinthestableperiod.AlowstableperiodFCFEestimatewillresultinalowestimateofvaluetoday.Thesolutionistouseaworking

    capitalratioclosertothelongrunindustryaverage.

    Ifthecostofequityestimateinthestablegrowthperiodistoohigh,theterminalvaluewillbetoolow.Becausetheterminalvalue

    typicallymakesupalargeportionofthecurrentvalue,thiswillcausethecurrentvalueestimatetobetoolow.Thesolutionistousea

    costofequityestimatebasedonabetaofone.

    Ifearningsaretemporarilydepressed,alltheFCFEestimateswillbelow,andthecurrentvalueestimatewillbelow.Thesolutionistouse

    anestimateoflongrunnormalizedearnings.

    Afirmcurrentlyhasthefollowingpersharevalues:

    Cashflowfromoperations(CFO)is$49.50.

    Investmentinfixedcapitalis$40.00.

    Netborrowingis$7.50.

    Whatisthecurrentpersharefreecashflowtoequity(FCFE)?

    $97.00.

    $16.50.

    $17.00.

    Explanation

    FCFE=CFOFCInv+netborrowing=$49.50$40.00+$7.50=$17.00

    TheprimarydifferencebetweenthethreestageDDMandtheFCFEmodelis:

    growthrateassumptions.

    costofequity.

    thedefinitionofcashflows.

    Explanation

    Theprimarydifferencebetweenthedividenddiscountmodelsandthefreecashflowfromequitymodelsliesinthedefinitionofcash

    flows.TheFCFEmodelusesresidualcashflowsaftermeetingallfinancialobligationsandinvestmentneeds.TheDDMusesastrict

    definitionofcashflowstoequity,thatis,theexpecteddividendsonthestock.

  • Question#97of145 QuestionID:463171

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    B)

    C)

    Question#98of145 QuestionID:463172

    A)

    B)

    C)

    Question#99of145 QuestionID:463169

    A)

    B)

    C)

    Question#100of145 QuestionID:463196

    Freecashflow(FCF)approachesarethebestsourceofvaluewhen:

    afirmhaspreferredstock.

    afirmispayingadividendthatishigherthantheindustryaverage.

    FCFstrackprofitabilitycloselyovertheanalyst'sforecasthorizon.

    Explanation

    FCFapproachesarebestwhenthoseflowsareagoodindicationofafirm'sprofitabilityovertheanalyst'sforecasthorizon.

    Freecashflowapproachesarethebestsourceofvaluewhen:

    dividendsarenotpaid.

    afirmhassignificantminorityinterest.

    returnonassetsisfalling.

    Explanation

    Freecashflowapproachesarebestwhendividendsarenotpaid.Bothremainingresponseshavenothingtodowiththedecision.

    IfafirmisvaluedusingFCFF,therelevantdiscountrateisthe:

    aftertaxweightedaveragecostofcapital.

    beforetaxweightedaveragecostofcapital.

    beforetaxcostofequity.

    Explanation

    SincetheFCFFisthecashavailabletoalltheinvestors,theaftertaxweightedaveragecostofcapitalshouldbeusedasthediscount

    rateinFCFFmodels.

    Usingtheinformationbelow,valuethestockofSymphonyPublishing,Inc.usingthefreecashflowfromequity(FCFE)valuationmethod.

    Requiredreturnof13.0%.

    Valueattheendofyear3of13timesFCFE .

    Sharesoutstanding:10.0million.

    3

  • A)

    B)

    C)

    Question#101of145 QuestionID:463233

    A)

    B)

    C)

    Netincomeinyear1of$10.0million,projectedtogrowat10%forthenexttwoyears.

    Depreciationperyearof$3.0million.

    CapitalExpendituresperyearof$2.5million.

    Increaseinworkingcapitalperyearof$1.0million.

    Principalrepaymentsondebtperyearof$1.5million.

    ThevaluepershareofSymphonyPublishingisapproximately:

    $11.21.

    $112.10.

    $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) ,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) ,orFV=9.0,I=13,PMT=0,N=2,ComputePV

    Year3:10.0(1.10) +3.02.51.01.5=10.10

    PV=7.00=10.10/(1.13) ,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) ,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

    Abiotechfirmiscurrentlyexperiencinghighgrowthandpaysnodividends.Oneoftheirproductpatentsisscheduledtoexpirein5years.

    Thisfirmwouldbeagoodcandidateforwhichofthefollowingvaluationmodels?

    Twostagedividenddiscountmodel(DDM).

    Twostagefreecashflowtoequity(FCFE).

    Singlestagefreecashflowtoequity(FCFE).

    Explanation

    1

    2

    2

    3

    3

  • Question#102of145 QuestionID:463254

    A)

    B)

    C)

    ThetwostageFCFEmodeliswellsuitedtovalueafirmthatiscurrentlyexperiencinghighgrowthandwilllikelyseethisgrowthdroptoa

    lower,morestablerateinthefuture.

    BOX,Inc.,earned$4.55persharelastyear.Thefirmhadcapitalexpendituresof$1.75pershareanddepreciationexpenseof$1.05.

    BOX,Inc.,hasatargetdebtratioof0.25.

    HighGrowth

    PeriodTransitionalPeriod StableGrowthPeriod

    Duration 2Years 5Years

    Earningsgrowthrate 45%

    Willdecline8%peryear

    to

    5%inthestablegrowth

    period

    5%

    GrowthinCapital

    Expenditures30%

    Increasesby8%per

    year

    Same$amountas

    Depreciation

    GrowthinDepreciation 30%Increasesby13%per

    year

    Same$amountas

    Capital

    Expenditures

    ChangeinWorking

    CapitalGivenBelow GivenBelow

    $2.25pershareinYear

    8

    ShareholderRequired

    Return25% 15% 10%

    Yr0 Yr1 Yr2 Yr3 Yr4 Yr5 Yr6 Yr7

    Earningspershare(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

    (WC)0.90 1.10 1.40 1.60 1.80 2.00 2.20 2.10

    Freecashflowtoequity

    (FCFE) 7.63 11.01 14.67 18.08 20.62 21.89

    WhatisthepresentvalueofBOX,Inc.?

    $195.71.

    $212.91.

    $223.65.

    Explanation

    Year1FCFE=Earningspershare(CapitalExpendituresDepreciation)(1DebtRatio)(Changeinworkingcapital)(1DebtRatio)

    =6.60(2.281.37)(10.25)(1.1)(10.25)=5.09.

  • Question#103of145 QuestionID:463216

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    B)

    C)

    Question#104of145 QuestionID:463177

    A)

    B)

    C)

    Questions#105110of145

    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+7.63/1.25 +11.01/[(1.25) (1.15) ]+14.67/[(1.25) (1.15) ]+18.08/

    [(1.25) (1.15) ]+20.62/[(1.25) (1.15) ]+21.89/[(1.25) (1.15) ]+475.80/[(1.25) (1.15) ]=

    4.07+4.88+6.13+7.10+7.61+7.55+6.97+151.40=195.71

    Dividendspaidouttotheshareholders:

    arealwayslessthanfreecashflowtoequity(FCFE).

    maybehigherthanfreecashflowtoequityFCFE.

    arealwaysequaltofreecashflowtoequity(FCFE).

    Explanation

    Dividendsrepresentthecashthatthefirmchoosestopaytotheshareholdersandtheamountofthedividendissubjecttothediscretion

    ofthefirm.Dividendscanbeequalto,lowerorhigherthanFCFE.Forexample,sometimesfirmsmaypaydividendsinyearswhenthere

    isanetloss.

    Freecashflow(FCF)approachesarethebestsourceofvaluewhen:

    afirmhasnopreferredstock.

    dividendsarepaidbutdonotreflectthecompany'scapacitytopaydividends.

    afirmhassignificantminorityinterest.

    Explanation

    FCFapproachesarebestwhendividendsarepaidbutdonotappeartoberepresentativeofthefirm'scapacitytopaythem.Both

    remainingresponseshavenothingtodowiththedecision.

    TOY,Inc.isacompanythatmanufacturesdolls,games,andotheritemstoentertainchildren.

    ThefollowingtableprovidesbackgroundinformationforTOY,Inc.onapersharebasisintheyear0:

    CurrentInformation Year0

    Earnings $5.00

    CapitalExpenditures $2.40

    Depreciation $1.80

    ChangeinWorkingCapital $1.70

    2 2 1 2 2

    2 3 2 4 2 5 2 5

  • Question#105of145 QuestionID:463314

    A)

    B)

    C)

    Question#106of145 QuestionID:463315

    A)

    B)

    C)

    Question#107of145 QuestionID:463316

    A)

    B)

    C)

    Costofequity 12.0%

    Targetdebtratio 30.0%

    Marketvalueofstock $56.00

    Sharesoutstanding 5.0million

    Interestexpense $7.2million

    Cash&shortterm

    investments$40.0million

    Taxrate 37.5%

    Earnings,capitalexpenditures,depreciation,andworkingcapitalareallexpectedtogrowby5.0%peryearinthefuture.

    Inyear1,theforecastedfreecashflowtoequity(FCFE)forTOY,Inc.isclosestto:

    $3.56.

    $4.53.

    $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)

    ThevalueofTOY,Inc.'sstockgiventheaboveassumptions,isclosestto:

    $50.86.

    $64.71.

    $61.57.

    Explanation

    Thevalueofthestock=FCFE /(rg )=3.56/(0.120.05)=50.86.

    (LOS36.j)

    ComparingthecurrentmarketvalueofTOYtoourestimateofthestock'scurrentmarketvalue,itismostlikelythatatthecurrentmarket

    priceof$56.00,TOYInc.stockis:

    fairlyvalued.

    undervalued.

    overvalued.

    1 n

  • Question#108of145 QuestionID:463317

    A)

    B)

    C)

    Question#109of145 QuestionID:463318

    A)

    B)

    C)

    Question#110of145 QuestionID:463319

    A)

    B)

    Explanation

    Ourcalculatedvalueofthestock=FCFE /(rg )=3.56/(0.120.05)=$50.86.Thecurrentmarketpriceis$56.00,becausethe

    marketpriceisgreaterthantheestimatedprice,thestockisovervaluedinthemarket.

    (LOS36.m)

    SeniormanagementofTOYInc.isconsideringsellingthecompanytoarivalfirmthathasoffered$450million.Ifthecurrentmarketprice

    representsthefairvalueofequityandTOYInc.maintainsitstargetcapitalstructure,thebidrepresentsapricethatis:

    greaterthanthetotalvalueofthefirm.

    lessthanthetotalvalueofthefirm.

    aboutthesametotalvalueofthefirm.

    Explanation

    Thetotalvalueofafirmisthetotalmarketvalueofequityplusthetotalmarketvalueofdebt.Thetotalvalueofequityis$56.00per

    share5,000,000shares=$280million.Equityrepresents70.0%ofthecapitalstructure.Thetotalvalueofthefirmisthus$280

    million/0.70=$400million.Anofferof$450millionisapremiumof$50millionapricegreaterthanthecurrentvalueofthefirm.

    (LOS36.m)

    TheEV/EBITDAratioforTOYInc.isclosestto:

    6.4x.

    4.3x

    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)

    Oneyearlatertheenterprisevalueincreasedby5.0%whiletheEBITDAis$59.0million.IftheEV/EBITDAfortheindustryis7.0,

    relativetoitspeers,TOYismostlikely:

    undervalued.

    overvalued.

    1 n

  • C)

    Question#111of145 QuestionID:463224

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    B)

    C)

    Question#112of145 QuestionID:463170

    A)

    B)

    C)

    Question#113of145 QuestionID:463189

    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)

    Ignoringanycostsrelatedtofinancialdistress,ifafirmincreasesitsfinancialleverage,thevalueofthefirmshould:

    decreasebecausetherequiredrateofreturnondebtislowerthanthatofequity.

    increasebecausetheweightedaveragecostofcapitalwillbelowerduetointeresttax

    shields.

    increasebecausetheFCFFwillincrease.

    Explanation

    Whenafirmaddsleverage,itsvaluemayincreaseduetothetaxshieldsoninterestexpenseandthegenerallylowercostofdebt.In

    theory,thereisanoptimalcapitalstructure.Iftheamountofdebtemployedisgreaterthantheoptimal,thecostsassociatedwithriskof

    bankruptcyorfinancialdistressbegintooutweightheadvantageofinteresttaxshields.

    Valuationwithfreecashflowtoequityandfreecashflowtothefirm:

    usedifferentdiscountrates.

    bothusethecostofequity.

    bothusetheaftertaxcostofdebt.

    Explanation

    Freecashflowtothefirmusestheweightedaveragecostofcapitalandfreecashflowtoequityusesthecostofequity.Thekeyisto

    useadiscountratethatreflectstheopportunitycostoftheindicatedinvestorgroup.

    ThefollowinginformationisderivedfromthefinancialrecordsofBrownCompanyfortheyearendedDecember31,2004:

    Sales $3,400,000

    CostofGoodsSold (2,100,000)

  • A)

    B)

    C)

    Question#114of145 QuestionID:463320

    A)

    B)

    C)

    (COGS)

    Depreciation (300,000)

    InterestPaid (200,000)

    GainonSaleofOld

    Equipment

    400,000

    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:

    $6,200,000.

    $200,000.

    $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).

    SudburyIndustriesexpectsFCFFinthecomingyearof400millionCanadiandollars($),andexpectsFCFFtogrowforeveratarateof3

    percent.Thecompanymaintainsanallequitycapitalstructure,andSudbury'srequiredrateofreturnonequityis8percent.

    SudburyIndustrieshas100millionoutstandingcommonshares.Sudbury'scommonsharesarecurrentlytradinginthemarketfor$80per

    share.

    UsingtheConstantGrowthFCFFValuationModel,Sudbury'sstockis:

    undervalued.

    overvalued.

    fairlyvalued.

    Explanation

    Basedonafreecashflowvaluationmodel,SudburyIndustriessharesappeartobefairlyvalued.

    SinceSudburyisanallequityfirm,WACCisthesameastherequiredreturnonequityof8%.

    ThefirmvalueofSudburyIndustriesisthepresentvalueofFCFFdiscountedbyusingWACC.SinceFCFFshouldgrowataconstant3

  • Question#115of145 QuestionID:463220

    A)

    B)

    C)

    Question#116of145 QuestionID:463241

    A)

    B)

    C)

    Question#117of145 QuestionID:463198

    percentrate,theresultis:

    Firmvalue=FCFF /WACCg=400million/0.080.03=400million/0.05=$8,000million

    Sincethefirmhasnodebt,equityvalueisequaltothevalueofthefirm.Dividingthe$8,000millionequityvaluebythenumberof

    outstandingsharesgivestheestimatedvaluepershare:

    V =$8,000million/100millionshares=$80.00pershare

    Whichofthefollowingisleastlikelytochangeasthefirmchangesleverage?

    Freecashflowstofirm(FCFF).

    Freeca