04 free cash flow valuation

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cfa level 2 free cash flow valuation

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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.ThefirstissuethatHodgeshadwasthathecalculatedtheequityvalueofafirmusingbothfreecashflowtoequitybasedanddividendbasedv