Reading 21 Free Cash Flow Valuation - Answers

Question #1 of 137 Question ID: 1472946
Free cash flow approaches are the best source of value when:
A) return on assets is falling.

B) dividends are not paid.
C) a firm has significant minority interest.
Explanation
Free cash flow approaches are best when dividends are not paid. Both remaining
responses have nothing to do with the decision.
(Module 21.1, LOS 21.a)
The stable-growth free cash flow to the firm (FCFF) model is most useful in valuing firms that:
A) have capital expenditures that are significantly higher than depreciation.

B) are growing at a rate significantly lower than that of the overall economy.
C) have capital expenditures that are not significantly higher than depreciation.
Explanation
The stable-growth FCFF model is useful for valuing firms that are expected to have growth
rates close to that of the overall economy. Since the rate of growth approximates that for
the overall economy, these firms should have capital expenditures that are not
significantly different than depreciation.
(Module 21.5, LOS 21.j)
Which of the following is most useful in analyzing firms that have high leverage and high
growth?
A) Two-stage free cash flow to the firm (FCFF) model.

B) Two-stage free cash flow to equity (FCFE) model.
C) Stable-growth free cash flow to the firm (FCFF) model.
Explanation
Of the cash flow valuation models mentioned above, the two-stage FCFF model is most
useful in analyzing the firms that have high leverage and high growth. The high growth will
make the stable growth models inapplicable, while the high leverage makes the FCFF
model more attractive.

What is the most likely reason that you get an extremely low value from the three-stage FCFE
model? Capital expenditures are significantly:
A) higher than depreciation in the stable-growth phase.

B) less than depreciation during the high-growth phase.
C) higher than depreciation during the high-growth phase.
Explanation
If capital expenditures estimates are significantly higher than depreciation for the stable
growth period, then the three-stage FCFE model might result in an extremely low value.
One possible solution for the problem is to grow the capital expenditures more slowly
than deprecation in the transition period to narrow the difference. Another is to assume
that capital expenditures and depreciation will offset when growth normalizes.
Burcar-Eckhardt, a firm specializing in value investments, has been approached by the management of Overhaul
Trucking, Inc., to explore the possibility of taking the firm private via a management buyout. Overhaul's stock has
stumbled recently, in large part due to a sudden increase in oil prices. Management considers this an opportune time
to take the company private. Burcar would be a minority investor in a group of friendly buyers.
Jaimie Carson, CFA, is a private equity portfolio manager with Burcar. He has been asked by Thelma Eckhardt, CFA,
one of the firm's founding partners, to take a look at Overhaul and come up with a strategy for valuing the firm. After
analyzing Overhaul's financial statements as of the most recent fiscal year-end (presented below), he determines that
a valuation using Free Cash Flow to Equity (FCFE) is most appropriate. He also notes that there were no sales of PPE.
Overhaul Trucking, Inc.
Income Statement
April 30, 2005
(Millions of dollars)
2005 2006E
Sales 300.0 320.0
Gross Profit 200.0 190.0
SG&A 50.0 50.0
Depreciation 70.0 80.0
EBIT 80.0 60.0
Interest Expense 30.0 34.0
Taxes (at 35 percent) 17.5 9.1
Net Income 32.5 16.9
Overhaul Trucking, Inc.
Balance Sheet
April 30, 2005

(Millions of dollars)
2005 2006E
Cash 10.0 15.0
Accounts Receivable 50.0 55.0
Gross Property, Plant & Equip. 400.0 480.0
Accumulated Depreciation (160.0) (240.0)
Total Assets 300.0 310.0
Accounts Payable 50.0 70.0
Long-Term Debt 140.0 113.1
Common Stock 80.0 80.0
Retained Earnings 30.0 46.9
Total Liabilities & Equity 300.0 310.0
Eckhardt agrees with Carson's choice of valuation method, but her concern is Overhaul's debt ratio. Considerably
higher than the industry average, Eckhardt worries that the firm's heavy leverage poses a risk to equity investors.
Overhaul Trucking uses a weighted average cost of capital of 12% for capital budgeting, and Eckhardt wonders if that's
realistic.
Question #5 - 8 of 137 Question ID: 1473065
Which of the following is one of the differences between FCFE and FCFF? FCFF does not
deduct:
A) operating expenses.
B) working capital investment.
C) interest payments to bondholders.
Explanation
FCFF includes the cash available to all of the firm's investors, including bondholders.
Therefore, interest payments to bondholders are not removed from revenues to derive
FCFF. FCFE is FCFF minus interest payments to bondholders plus net borrowings from
bondholders.
(Module 21.5, LOS 21.i)
Which of the following is the least likely reason for Carson's decision to use FCFE in valuing
Overhaul rather than FCFF?
A) Overhaul’s capital structure is stable.

B) FCFE is an easier and more straightforward calculation than FCFF.
C) Overhaul’s debt ratio is significantly higher than the industry average.
Explanation
The difference between FCFF and FCFE is related to capital structure and resulting interest
expense. When the company's capital structure is relatively stable, FCFE is easier and more
straightforward to use. FCFF is generally the best choice when FCFE is negative or the firm
is highly leveraged. The fact that Overhaul's debt ratio is significantly higher than the
industry average would argue against the use of FCFE. Hence, this is the least likely reason
to favor FCFE.
What is the expected growth rate in FCFF that Carson must have used to generate his
valuation of $1.08 billion?
A) 5%.
B) 7%.
C) 12%.
Explanation
Since Firm Value = FCFF1 / (WACC − g), we first need to determine FCFF1, which is FCFF in
2006: FCFF = NI + NCC + [Int × (1 − tax rate)] – FCInv − WCInv
= 16.9 + 80 + [34 × (1 − 0.35)] − (480 − 400) − [(55 − 70) − (50 − 50)]
= 16.9 + 80 + 22.1 − 80 − (−15) = 54
Firm Value = FCFF1 / (WACC − g)
1080 = 54 / (0.12 − x)
[(1080)(0.12)] − 1080x = 54
129.6 − 1080x = 54
75.6 = 1080x
0.07 = x
The expected growth rate in FCFF that Carson must have used is 7%.
If Carson had estimated FCFE under the assumption that Overhaul Trucking maintains a
target debt-to-asset ratio of 36 percent for new investments in fixed and working capital,
what would be his forecast of 2006 FCFE?
A) $26.5 million.
B) $9.6 million.
C) $16.9 million.
Explanation
FCFE = NI – [(1 − DR) × (FCInv − Dep)] − [(1 − DR) × WCInv]
Where: DR = target debt to asset ratio
FCFE = 16.9 − [(1 − 0.36) × (480 − 400 − 80)] − [(1 − 0.36) × ((55 − 70) − (50 − 50))]
= 16.9 − (0.64 × 0) − (0.64 × (−15))
= 16.9 + 0 + 9.6 = 26.5
In forecasting free cash flows it is most common to assume that:
A) historical levels of free cash flow will persist.

B) the firm has no non-cash expenses.
C) the firm capital structure is static.
Explanation
A firm's target debt ratio is usually assumed to remain constant. Historical cash flows are
generally projected forward with a growth rate.
(Module 21.5, LOS 21.e)
Free cash flow to the firm is equal to cash flow from operations minus fixed capital
investment:
A) minus after-tax interest expense.

B) plus after-tax interest expense.
C) minus pre-tax interest expense.
Explanation
Free cash flow to the firm is equal to cash flow from operations minus fixed capital
investment plus after-tax interest expense.
(Module 21.2, LOS 21.c)
Dividends paid out to the shareholders:
A) may be higher than free cash flow to equity FCFE.

B) are always less than free cash flow to equity (FCFE).
C) are always equal to free cash flow to equity (FCFE).
Explanation
Dividends represent the cash that the firm chooses to pay to the shareholders and the
amount of the dividend is subject to the discretion of the firm. Dividends can be equal to,
lower or higher than FCFE. For example, sometimes firms may pay dividends in years when
there is a net loss.
(Module 21.5, LOS 21.f)
A biotech firm is currently experiencing high growth and pays no dividends. One of their
product patents is scheduled to expire in 5 years. This firm would be a good candidate for
which of the following valuation models?
A) Two-stage dividend discount model (DDM).

B) Two-stage free cash flow to equity (FCFE).
C) Single-stage free cash flow to equity (FCFE).
Explanation
The two-stage FCFE model is well suited to value a firm that is currently experiencing high
growth and will likely see this growth drop to a lower, more stable rate in the future.
Which of the following free cash flow to equity (FCFE) models is most suited to analyze firms
in an industry with significant barriers to entry?
A) Two-stage FCFE Model.

B) FCFE Perpetuity Model.
C) Stable Growth FCFE Model.
Explanation
The two-stage FCFE model is most suited for analyzing firms in high growth that will
maintain that growth for a specific period, such as firms with patents or firms in an
industry with significant barriers to entry.
Free cash flow (FCF) approaches are the best source of value when:
A) a firm has no preferred stock.

B) dividends are paid but do not reflect the company's capacity to pay dividends.
C) a firm has significant minority interest.
Explanation
FCF approaches are best when dividends are paid but do not appear to be representative
of the firm's capacity to pay them. Both remaining responses have nothing to do with the
decision.
If the investment in fixed capital and working capital offset each other, free cash flow to the
firm (FCFF) may be proxied by:
A) earnings before interest and taxes (EBIT).

B) after-tax EBIT plus non-cash charges.
C) net income plus after-tax interest.
Explanation
The answer is indicated by the definition of FCFF: FCFF = EBIT (1 – tax rate) + Dep – FCInv –
WCInv, which assumes that depreciation is the only non-cash charge. Further: FCFF = NI +
NCC + Int (1 – tax rate) – FCInv – WCInv.
(Module 21.5, LOS 21.h)
A firm has projected free cash flow to equity next year of $1.25 per share, $1.55 in two years,
and a terminal value of $90.00 two years from now, as well. Given the firm's cost of equity of
12%, a weighted average cost of capital of 14%, and total outstanding debt of $30.00 per
share, what is the current value of equity?
A) $71.74.
B) $74.10.
C) $41.54.
Explanation
Value of equity = $1.25 / (1.12)1 + $1.55 / (1.12)2 + $90.00 / (1.12)2 = $74.10
(Module 21.5, LOS 21.k)
Which of the following types of company is the E-Model, a three-stage free cash flow to
equity (FCFE) Model, best suited for? Companies:
A) with patents or firms in an industry with significant barriers to entry.

growing at a rate similar to or less than the nominal growth rate of the
B)
economy.
in high growth industries that will face increasing competitive pressures over
C)
time, leading to a gradual decline in growth to a stable level.
Explanation
The three-stage FCFE model, or E-Model, is most suited to analyzing firms currently
experiencing high growth that will face increasing competitive pressures over time, leading
to a gradual decline in growth to a stable level. The two-stage model is best suited to
analyzing firms in a high growth phase that will maintain that growth for a specific period,
such as firms with patents or firms in an industry with significant barriers to entry.
Companies growing at a rate similar to or less than the nominal growth rate of the
economy are best suited for the Stable Growth FCFE Model. A firm that pays out all of its
earnings as dividends will have a growth rate of zero (remember g = RR × ROE) and would
not be valued using the three-stage FCFE model.
In computing free cash flow, the most significant non-cash expense is usually:
A) deferred taxes.
B) capital expenditures.
C) depreciation.
Explanation
Depreciation is usually the largest non-cash expense.
Using the stable growth free cash flow to the firm (FCFF) model, what is the value of Quality
Builders under the assumptions contained in the table below?
Quality Builders
Free Cash Flow to the Firm
Year 0
EBIT $500
Depreciation $200
Capital Spending $300
Working Capital Additions $30
Tax Rate 40%
Assumed Constant Growth Rate in Free Cash Flow 5%
Weighted-average Cost of Capital 11%
A) $6,475.00.
B) $2,975.00.
C) $2,833.33.
Explanation
The stable growth FCFF model assumes that FCFF grows at a constant rate forever. FCFF in
Year 0 is equal to EBIT(1 − tax rate) + Depreciation − Capital Spending − Working Capital
Additions = 500(1 − 0.4) + 200 − 300 − 30 = 170. The Firm Value = FCFF1 / (r − gn) =
170(1.05) / (0.11 − 0.05) = $2,975.
SOX Inc. expects high growth in the next 4 years before slowing to a stable future growth of
3%. The firm is assumed to pay no dividends in the near future and has the following
forecasted free cash flow to equity (FCFE) information on a per share basis in the high-
growth period:
Year 1 Year 2 Year 3 Year 4
FCFE $3.05 $4.10 $5.24 $6.71
High-growth period assumptions:
SOX Inc.'s target debt ratio is 40% and a beta of 1.3.

The long-term Treasury Bond Rate is 4.0%, and the expected equity risk premium is
6%.
Stable-growth period assumptions:
SOX Inc.'s target debt ratio is 40% and a beta of 1.0.

The long-term Treasury Bond Rate is 4.0% and the expected equity risk premium is
6%.
Capital expenditures are assumed to equal depreciation.
In year 5, earnings are $8.10 per share while the change in working capital is $2.00 per
share.
Earnings and working capital are expected to grow by 3% a year in the future.
In year 5, what is the free cash flow to equity (FCFE) for SOX Inc.?
A) $7.30.
B) $6.10.
C) $6.90.
Explanation
In year 5, FCFE = Earnings per share − (Capital Expenditures − Depreciation) (1 − Debt

Ratio) − (Change in working capital)(1 − Debt Ratio) = 8.10 − 0(1 − 0.4) − 2.00(1 − 0.4) = 6.90.
(Module 21.4, LOS 21.d)
Which of the following statements is least accurate? A firm's free cash flows to equity (FCFE)
is the cash available to stockholders after funding:
A) capital expenditure requirements.

B) debt principal repayments.
C) dividend payments.
Explanation
A firm's FCFE is the cash available to stockholders after funding capital expenditures and
debt principal repayments.
TOY, Inc. is a company that manufactures dolls, games, and other items to entertain children.
The following table provides background information for TOY, Inc. on a per share basis in the year 0:
Current Information Year 0
Earnings $5.00
Capital Expenditures $2.40
Depreciation $1.80
Change in Working Capital $1.70
Cost of equity 12.0%
Target debt ratio 30.0%
Market value of stock $56.00
Shares outstanding 5.0 million
Interest expense $7.2 million
Cash & short-term investments $40.0 million
Tax rate 37.5%
Earnings, capital expenditures, depreciation, and working capital are all expected to grow by 5.0% per year in the
future.
In year 1, the forecasted free cash flow to equity (FCFE) for TOY, Inc. is closest to:
A) $3.56.
B) $4.31.
C) $4.53.
Explanation
FCFE year 0 = Earnings per share − [(Capital Expenditures − Depreciation) × (1 − Debt

Ratio)] − [(Change in working capital) × (1 − Debt Ratio)] = 5.00 − [(2.40 − 1.80) × (1 − 0.30)]
− [(1.70) × (1 − 0.30)] = 3.39.
FCFE for year 1 = FCFE year 0 × (1 + growth rate) = 3.39 × (1.05) = $3.56.
(Module 21.5, LOS 21.m)

The value of TOY, Inc.'s stock given the above assumptions, is closest to:
A) $50.86.
B) $64.71.
C) $61.57.
Explanation
The value of the stock = FCFE1 / (r − gn) = 3.56 / (0.12 − 0.05) = 50.86.
Comparing the current market value of TOY to our estimate of the stock's current market
value, it is most likely that at the current market price of $56.00, TOY Inc. stock is:
A) overvalued.
B) undervalued.
C) fairly valued.
Explanation
Our calculated value of the stock = FCFE1 / (r − gn) = 3.56 / (0.12 − 0.05) = $50.86. The
current market price is $56.00, because the market price is greater than the estimated
price, the stock is overvalued in the market.
Senior management of TOY Inc. is considering selling the company to a rival firm that has
offered $450 million. If the current market price represents the fair value of equity and TOY
Inc. maintains its target capital structure, the bid represents a price that is:
A) less than the total value of the firm.

B) about the same total value of the firm.
C) greater than the total value of the firm.
Explanation
The total value of a firm is the total market value of equity plus the total market value of
debt. The total value of equity is $56.00 per share × 5,000,000 shares = $280 million.
Equity represents 70.0% of the capital structure. The total value of the firm is thus $280
million/0.70 = $400 million. An offer of $450 million is a premium of $50 million – a price
greater than the current value of the firm.

Free cash flow to the firm (FCFF) adjusts earnings before interest and taxes (EBIT) by:
deducting taxes, adding back depreciation, and deducting the investments in

A)
fixed capital and working capital.
B) subtracting investments in fixed capital and working capital.
adding taxes, deducting depreciation, and adding back the investments in fixed
C)
capital and working capital.
Explanation
As presented in the reading: FCFF = EBIT (1 – tax rate) + Dep – FCInv – WCInv.
The ownership perspective implicit in the free cash flow to equity valuation approach is of:
A) control.
B) a preferred stockholder.
C) a minority position.
Explanation
Dividend policy can be changed by the buyer of a firm. Thus, the free cash flow
perspective looks to the source of dividends in a position of control rather than directly at
dividends.
(Module 21.1, LOS 21.b)
The two-stage (stable growth) free cash flow to equity (FCFE) and free cash flow to the firm
(FCFF) models typically assume:
a high level of free cash flow for n years and then a lower level of free cash flow
A)
thereafter.
high growth in free cash flow for n years and then constant growth in free cash
B)
flow forever after.
growth of free cash flow that declines to the required rate of return in the last
C)
stage.
Explanation
The two-stage model using either FCFE or FCFF typically assumes a high growth of free
cash flow for n years and then a constant growth in free cash flow forever after. Multi-
stage models assume that the required rate of return exceeds the growth rate in the last
stage. In a two-stage free cash flow models, the growth rate in the second stage
represents the long-run sustainable growth rate, which is generally a low rate that is close
to the GDP growth rate.
The stable-growth free cash flow to equity (FCFE) model is best suited for which of the
following types of companies? Companies:
A) with patents that will not expire for 20 or more years.

B) growing at a rate similar or less than the nominal growth rate of the economy.
C) with significant barriers to entry.
Explanation
Companies growing at a rate similar to or less than the nominal growth rate of the
economy are best suited for the Stable Growth FCFE Model. The three-stage FCFE model is
most suited to analyzing firms currently experiencing high growth that will face increasing
competitive pressures over time, leading to a gradual decline in growth to a stable level.
The two-stage model is best suited to analyzing firms in a high growth phase that will
industry with significant barriers to entry.
The one-stage (stable growth) free cash flow models assume:
A) the required rate of return exceeds the growth rate.

B) the required rate of return is less than the growth rate.
C) a constant growth rate for n years and a high growth rate forever thereafter.
Explanation
The one-stage model using either free cash flow to equity (FCFE) or free cash flow to the
firm (FCFF) assumes that the required rate of return exceeds the growth rate. If this was
not the case, the model would produce an unrealistic negative price.

A firm has:
Free cash flow to equity = $4.0 million.

Cost of equity = 12%.
Long-term expected growth rate = 5%.
Value of equity per share = $57.14 per share.
What will happen to the value of the firm if free cash flow to equity decreases to $3.2
million?
A) The value will increase.

B) There is insufficient information to tell.
C) The value will decrease.
Explanation
Everything else being constant, a decrease in free cash flow to equity should decrease the
value of the firm.
In the stable-growth FCFE model, an extremely low value can result from all of the following
EXCEPT:
A) the required rate of return is too high for a stable firm.

B) the expected growth rate is too high for a stable firm.
C) capital expenditures are too high relative to depreciation.
Explanation
If the expected growth rate is too high for a stable firm, the value obtained using the
stable-growth FCFE model will be extremely high.
Using the information below, value the stock of Symphony Publishing, Inc. using the free
cash flow from equity (FCFE) valuation method.
Required return of 13.0%.

Value at the end of year 3 of 13 times FCFE3.
Shares outstanding: 10.0 million.
Net income in year 1 of $10.0 million, projected to grow at 10% for the next two years.
Depreciation per year of $3.0 million.
Capital Expenditures per year of $2.5 million.
Increase in working capital per year of $1.0 million.
Principal repayments on debt per year of $1.5 million.
The value per share of Symphony Publishing is approximately:
A) $112.10.
B) $14.10.
C) $11.21.
Explanation
Step 1: Calculate each year's FCFE and discount at the required return.
FCFE = net income + depreciation − capital expenditures − increase in working
capital − principal repayments + new debt issues
Year 1: 10.0 + 3.0 − 2.5 − 1.0 − 1.5 = 8.0,
PV = 7.08 = 8.0 / (1.13)1, or FV = −8.0, I = 13, PMT = 0, N = 1, Compute PV
Year 2: 10.0 × 1.10 + 3.0 − 2.5 − 1.0 − 1.5 = 9.0,
Year 3: 10.0 × (1.10)2 + 3.0 − 2.5 − 1.0 − 1.5 = 10.10
Step 2: Calculate Present Value of final cash flow times FCFE multiple.
Value at end of year 3 = FCFE3 × multiple = 10.10 × 13 = 131.30
PV = 91.00 = 131.30 / (1.13)3 , or using calculator, N = 3, FV = −131.30, I = 13, PMT =
0, Compute PV
Step 3: Calculate per share value.

Add up PV of FCFE and end value and divide by number of shares outstanding
= (7.08 + 7.05 + 7.00 + 91.0) / 10.0 = 11.21
The primary difference between the three-stage DDM and the FCFE model is:
A) growth rate assumptions.

B) the definition of cash flows.
C) cost of equity.
Explanation
The primary difference between the dividend discount models and the free cash flow from
equity models lies in the definition of cash flows. The FCFE model uses residual cash flows
after meeting all financial obligations and investment needs. The DDM uses a strict
definition of cash flows to equity, that is, the expected dividends on the stock.
(Module 21.5, LOS 21.g)

BOX Inc. earned $4.55 per share last year. The firm had capital expenditures of $1.75 per
share and depreciation expense of $1.05. BOX Inc. has a target debt ratio of 0.25.
High-Growth Stable-Growth
Transitional Period
Period Period
Duration 2 Years 5 Years
Will decline 8% per

year to 5% in the
Earnings growth rate 45% 5%
stable-growth
period
Growth in Capital Increases by 8% per

30% Same as Depreciation
Expenditures year
Increases by 13% Same as Capital

Growth in Depreciation 30%
per year Expenditures
Change in Working $2.25 per share in

Given Below Given Below
Capital Year 8
Shareholder Required
25% 15% 10%
Return
Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7
EPS 4.55 6.60 9.57 13.11 16.91 20.46 23.12 24.27
Capital
1.75 2.28 2.96 3.19 3.45 3.73 4.02 4.35
Expenditures
Depreciation 1.05 1.37 1.77 2.01 2.27 2.56 2.89 3.27
Change in WC 0.90 1.10 1.40 1.60 1.80 2.00 2.20 2.10
FCFE 7.63 11.01 14.67 18.08 20.62 21.89
In year 1, what is the free cashflow to equity (FCFE) for BOX Inc.?
A) $5.09.
B) $3.35.
C) $6.10.
Explanation
Year 1 FCFE = Earnings per share − (Capital Expenditures – Depreciation) (1 − Debt Ratio) −
Change in working capital (1 − Debt Ratio)
Year 1 FCFE = 6.60 − (2.28 − 1.37)(1 − 0.25) – (1.1)(1 − 0.25) = 5.09
Which of the following items is NOT subtracted from the net income to calculate free cash
flow to equity (FCFE)?
A) Interest payments to bondholders.

B) increase in accounts receivable.
C) Increase in fixed assets.
Explanation
Interest payments to bondholders are included in the income statement and are already
subtracted to calculate net income.
Which of the following is least likely to change as the firm changes leverage?
A) Free cash flows to firm (FCFF).

B) Free cash flows to equity (FCFE).
C) Weighted average cost of capital (WACC).
Explanation
The FCFFs are normally unaffected by the changes in leverage, as these are the cash flows
before the debt payments.

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%.

Earnings 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.
Weighted average cost of capital (WACC) during high growth stage = 20%.
Weighted average cost of capital (WACC) during stable growth stage = 12%.
Year 0 (last
Scenario 2 FCFF Year 1 Year 2 Year 3 Year 4
year)
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
Given the assumptions contained in Scenario 2, what is the value of the firm?
A) $81.54.
B) $70.39.
C) $96.92.
Explanation
Use the two-stage FCFF model to value the firm. The Terminal Value of the firm as of Year
3 = 11.56 / (0.12 - 0.02) = 115.60. The value = 5.95 / (1.20) + 7.06 / (1.20)2 + (8.25 + 115.62) /
(1.20)3 = 81.54.
Which of the following statements regarding dividends and free cash flow to equity (FCFE) is
least accurate?
Required returns are higher in FCFE discount models than they are in dividend
A)
discount models, since FCFE is more difficult to estimate.
B) FCFE can be negative but dividends cannot.
FCFE discount models usually result in higher equity values than do dividend
C)
discount models (DDMs).
Explanation
Although FCFE may be more difficult to estimate than dividends, the required return is
based on the risk faced by the shareholders, which would be the same under both models.
The three-stage FCFE model might result in an extremely high value if:
A) the growth rate in the stable-period is too low.

B) the growth rate in the stable-period is too high.
C) the growth rate in the stable-period is equal to that of GNP.
Explanation
If the growth rate in the stable-period is too high or the high-growth and transition periods
are too long, the three-stage FCFE model might result in an extremely high value.
An analyst has prepared the following scenarios for Schneider Inc.:
Scenario 1 Assumptions:
Tax Rate is 40%.

Weighted average cost of capital (WACC) = 12.0%.
Constant growth rate in free cash flow (FCF) = 3.0%.
Year 0, free cash flow to the firm (FCFF) = $30.0 million
Target debt ratio = 10.0%.
Tax Rate is 40.0%.

Earnings before interest and taxes (EBIT), capital expenditures, and depreciation will grow at 20.0% for the next
three years.
After three years, the growth in EBIT will be 2.0%, and capital expenditure and depreciation will offset each
other.
Weighted average cost of capital (WACC) = 12.0%
Target debt ratio = 10.0%.
Scenario 2 FCFF (in $ millions) Year 0 Year 1 Year 2 Year 3 Year 4
EBIT $45.00 $54.00 $64.80 $77.76 $79.70
Depreciation 12.00 14.40 17.28 20.74
Change in Working Capital 6.00 6.30 6.60 7.20 7.20
FCFF 18.90 23.64 29.09 40.62
Other financial items for Schneider Inc.:

Estimated market value of debt = $35.0 million
Cost of debt = 5.0%
Shares outstanding = 20 million.
Given the assumptions contained in Scenario 1, the value of the firm is most accurately
estimated as:
A) $343 million.
B) $333 million.
C) $250 million.
Explanation
Under the stable growth FCFF model, the value of the firm = FCFF1 / (WACC − gn) = $30
million × (1.03) / (0.12 − 0.03) = $343.33 million.
In Scenario 2, the value of the firm is closest to:
A) $315 million.
B) $346 million.
C) $321 million.
Explanation
The value of the firm is the present value of Year 1-3 plus the terminal value. The terminal
value is: FCFF for year 4/(WACC – growth rate) = $40.62/(0.12 – 0.02) = $406.22 million in
terms of year 3 dollars. The calculator inputs to solve NPV for the value of the firm is: CF0
= $0, CF1 = $18.90, CF2 = $23.64, CF3 = $29.09 + $406.22 = $435.31, I =12. NPV = $345.57
million.
The cost of equity for Schneider Inc. is closest to:
A) 13.0%.
B) 5.8%.
C) 11.3%.
Explanation
The weighted average cost of capital formula is WACC = wd × rd × (1 − t) + we × re. The
weight of debt is 10.0% − the weight of equity must be 90.0%.
0.12 = 0.10 × 0.05 × (1 − 0.40) + 0.90 × re
0.120 - 0.003 = 0.90 × re
0.117/0.9 = re
re = 13.0%
The market value of Schneider Inc.'s stock is:
A) $17.50 per share.

B) $31.50 per share.
C) $15.75 per share.
Explanation
The estimated market value of debt is $35 million, which represents 10.0% of the value of
the firm. The other 90.0% is the value of equity or $315 million. $315 million/20 million
shares = $15.75 per share.
Ashley Winters, CFA, has been hired to value Goliath Communications, a company that is currently experiencing rapid
growth and expansion. Winters is an expert in the communications industry and has had extensive experience in
valuing similar firms. She is convinced that a value for the equity of Goliath can be reliably obtained through the use
of a three-stage free cash flow to equity (FCFE) model with declining growth in the second stage. Based on up-to-date
financial statements, she has determined that the current FCFE per share is $0.90. Winters has prepared a forecast of
expected growth rates in FCFE as follows:
Stage 1: 10.5% for years 1 through 3
Stage 2: 8.5% in year 4, 6.5% in year 5, 5.0% in year 6
Stage 3: 3.0% in year 7 and thereafter
Moreover, she has determined that the company has a beta of 1.8. The current risk-free rate is 3.0%, and the equity
risk premium is 5.0%.
Other financial information:
Outstanding shares 10 million
Tax rate 40.0%
Interest expense $750,000
Net borrowing −$100,000
Cost of debt 7.5%

Debt-to-equity ratio 25.0%
Estimated growth rate for the firm 4.0%
The terminal value in year 6 is closest to:
A) $16.86.
B) $21.68.
C) $25.29.
Explanation
Estimates for the future FCFE based on supplied growth rates are:
Year 1 2 3 4 5 6 7
Growth rate 10.5% 10.5% 10.5% 8.5% 6.5% 5.0% 3.0%
FCFE/share $0.995 $1.099 $1.214 $1.318 $1.403 $1.473 $1.518
R$ = 1.518/(12.0% - 3.0%) = 16.861
The per-share value Winters should assign to Goliath's equity is closest to:
A) $20.24.
B) $13.55.
C) $16.87.
Explanation
We find the value of the equity/share by discounting all future FCFE/share by the required
rate of return on equity.
0.995 1.099 1.214 1.318 1.403 1.473+16.867

value of equity/share = + + + + + = $13.55/ sha
2 3 4 5 6
(1.12) (1.12) (1.12) (1.12) (1.12) (1.12)
Using our calculator, enter CF0 = 0; C01 = 0.995; C02 = 1.099; C03 = 1.214; C04 = 1.318; C05
= 1.403; C06 = 1.473 + 16.867 = 18.34; I = 12; Compute →NPV = 13.55.
The weighted average cost of capital (WACC) is closest to:
A) 10.5%.
B) 10.9%.
C) 11.1%.
Explanation
The debt-to-equity ratio of 25.0% means that the debt-to-total value is 25.0%/125.0% or
20.0%. The weight of debt is thus 20.0% and the weight of equity is 80.0%.
The WACC = [0.20 × (0.075) × (1 – 0.40)] + (0.80 × 0.12) = 10.5%
The value of the firm, based on the constant growth model, is closest to:
A) $153 million.
B) $140 million.
C) $124 million.
Explanation
The estimated FCFF for year 0 is $9.55 million and the WACC is 10.5% as calculated. If the
growth rate for the firm is estimated as 4.0%, the value of the firm is:
$9.55 million × (1.04)/(0.105 – 0.04) = $152,800,000.
The ownership perspective implicit in the dividend valuation approach is of:
A) a preferred stockholder.
B) control.
C) a common stockholder.
Explanation
Dividends are most relevant to the stockholders who receive them and who have little
control over their amount.

On a per share basis for a firm:
Sales are $10.00.

Earnings per share (EPS) is $4.00.
Depreciation is $3.00.
After-tax interest is $2.40.
Investment in working capital is $1.50.
Investment in fixed capital is $2.00.
What is the firm's expected free cash flow to the firm (FCFF) per share?
A) $5.90.
B) $7.50.
C) $2.90.
Explanation
FCFF = EPS + net non-cash charges + after-tax interest − FCInv − WCInv
FCFF= $4.00 + 3.00 +$2.40 − $2.00 −1.50 = $5.90
The two-stage FCFE model is suitable for valuing firms that:
A) have very high but declining growth rate in the initial stage.
have moderate growth in the initial phase that declines gradually to a stable
B)
rate.
C) are in an industry with significant barriers to entry.
Explanation
The two-stage FCFE model is suitable for valuing firms in industries with significant
barriers to entry. Where these are present it is possible for the firm to maintain a high
growth rate during an initial phase of low competition, and that the rate will drop sharply
to a normalized rate when competition ultimately appears.
William Bolton is an avid disc golf player and the owner of Deep in the Game Discs (DITGD), a business involved in
wholesale distribution of discs and other disc golf equipment. DITGD supplies smaller outlets within the U.S. market
and exports overseas. Will has built his business organically over a 20-year period, starting as a hobby but developing
into a mid-sized business.
Will has recently lost some UK export customers to a smaller UK located competitor called Fishy Discs Ltd. Will
recently met Neil Prebble, the owner of Fishy Discs at a trade fair and was considering a friendly acquisition in order
to expand his business into the UK market.
Will has employed an accountancy firm with a corporate finance division, to give him some indication of a price to
offer for Fishy Discs.
Exhibit 1: Fishy Discs—Selected Financial Information
Income Statement Period Ended 31st December 20x9

£ £
Sales revenue 200,000
Expenses:
Cost of goods sold 80,000
Salaries 10,000
Depreciation 14,000
Interest 1,000
105,000
95,000
Gain from sale of PP&E 20,000
Pre-tax income 115,000
Provision for taxes 40,000
Net income 75,000
Balance Sheet Year Ended 20x9
20x8 20x9
£ £
Current Assets
Cash 18,000 66,000
Accounts receivable 18,000 20,000
Inventory 14,000 10,000
Non-Current Assets
Gross PP&E 282,000 312,000
Accumulated depreciation (80,000) (84,000)
Total Assets 252,000 324,000
Current Liabilities
Accounts payable 10,000 18,000
Salaries payable 16,000 9,000
Interest payable 6,000 7,000
Taxes payable 8,000 10,000
Dividends payable 2,000 12,000
Non-Current Liabilities
Long term debt 20,000 30,000
Deferred tax 30,000 40,000
Stockholders' Equity
Contributed capital 100,000 80,000
Retained earnings 60,000 118,000
Liabilities and Equity 252,000 324,000
On review of the PP&E footnote disclosure, it is discovered that equipment with a carrying value of £10,000 had been
disposed of during 20x9.
All long-term debt is issued with a coupon such that the debt will trade at par value on issuance.
The effective tax rate relating to Fishy Discs is 40%.
Deferred tax liabilities are not expected to reverse for the foreseeable future.
The corporate finance firm employed by Will has decided to value Fishy Discs based on sustainable free cash flow,
after removing one off items from the cash flow statement. In addition, they have considered how long Fishy Discs will
be able to maintain its cash flow growth rates. Fishy Discs currently is the only domestically located UK supplier of disc
golf equipment. Their results are included in Exhibit 2.
Exhibit 2: Fishy Discs Ltd. Valuation Data

Free cash flow to the firm £75,000
(base period estimate)
High growth rate 12%
Sustainable growth rate 4%
Duration of high growth 4 years
Declining growth duration 6 years
Cost of equity 10%
WACC 8%
The corporate finance team believes the market value of Fishy Discs debt is close to book value in the 20x9
accounts. The team believes that the decline in growth from 12% down to 4% will be linear.
Tony Cermak is a young modeler in the corporate finance team and he has raised a couple of comments regarding the
valuation figures prepared for Fishy Discs.
Concern 1: Fishy Discs reduced its inventory between 20x8 and 20x9. This lead to a boost of £4,000 in cash flows in
20x9. Given inventory, levels cannot decline below zero and we are forecasting Fishy Discs to grow, any
boost to cash flow from inventory reduction is likely to be transitory and should be removed from
sustainable cash flow.
Concern 2: Fishy Discs current high growth rates are linked to an exclusivity agreement that Prebble has with a U.S.
disc producer. This agreement gives Fishy Discs sole supplier status for the global number one selling
brand in the UK for a four-year period. At the end of this period, the U.S. supplier has indicated that
other firms will be allowed to import and retail these products in the UK market. Given this, I believe our
growth rate assumptions detailed in Exhibit 2 are unrealistic.
Tony has been given the firms free cash flow valuation model guide to study before he attempts to value Fishy Discs.
In particular, he is interested in the following formulas that have been given:
Exhibit 3: Cash Flow Valuation Guide Extract
FCFF from EBIT:
FCFF = EBIT(1 – T) + depreciation – FCINV – WCINV
FCFF from EBITDA:
FCFF = EBITDA(1 – T) + depreciation – FCINV – WCINV

Using the information available in Exhibit 1, Operating Cash Flow (CFO) for Fishy Discs is
closest to?
A) £73,000.
B) £75,000.
C) £85,000.
Explanation
CFO = NI + NCC – WCINV
Non-Cash Charges
+ Depreciation 14,000
– Gain on asset disposal (20,000)
+ Δ Deferred tax liability 10,000
Net impact 4,000
Working Capital Investment
20x9 20x8
CA – cash and investments 30,000 32,000
CL – debt instruments and dividends payable 44,000 40,000
Working capital (14,000) (8,000)
∆ in working capital –£6,000
Note that the change in the deferred tax liability (DTL) is only included, as it is not
expected to reverse. A DTL that is expected to reverse in the near term would be ignored.
Whilst the DTL represents a boost to operating cash flows when it is created, it will reduce
cash flows when it reverses. These two cash flow effects off set and as a result, it is best to
ignore the DTL when estimating free cash flow if it is expected to reverse in the short run.
CF0 = 75,000 + 4,000 + 6,000 = £85,000
Using the information available in Exhibit 1, capital expenditure for Fishy Discs is closest to?
A) £20,000.
B) £30,000.
C) £50,000.
Explanation
FCINV = change in carrying value + depn expense – gain on disposal
FCINV = 26,000 + 14,000 – 20,000 = 20,000
Alternatively
Compute additions to PP&E as a residual figure:
FCINV computation
PP&E 20x8 202,000 Proceeds (plug) 30,000
Depreciation (14,000) Carrying value (10,000)
Disposal (10,000) Gain/(loss) 20,000
Additions (plug) 50,000
PP&E 20X9 228,000
FCINV = £50,000 – £30,000 = £20,000
Note that additions and proceeds have been computed as residual (balancing) figures.
Assuming a CFO figure of £75,000 and capital expenditure of £20,000, Fishy Discs free cash
flow to the firm for 20x9 is closest to?
A) £55,600.
B) £65,000.
C) £75,600.
Explanation
FCFF = CFO + interest (1 – T) – FCINV
FCFF = £75,000 + £1,000 (1 – 0.4) – £20,000 = £55,600
Using only the corporate finance firm's data in Exhibit 2 and their growth assumptions, the
value of Fishy Discs Ltd.'s equity is closest to?
A) £2,033,000.
B) £3,075,000.
C) £3,105,000.
Explanation
Using the 3 stage DCF model:
CF1 = £84,000
CF2 = £94,080
CF3 = £105,370
CF4 = £118,014 + £708,084 + £3,068,364
I = 8 CPT →NPV = £3,104,628
Firm value = £3,104,628
Equity value = firm value – debt value
£3,074,628 = £3,104,628 – £30,000
How many on of Tony's concerns are valid?
A) Both.
B) Neither.
C) Only concern 2.
Explanation
Concern 1: He is correct that declines in inventory give one off boosts to cash flow from
operations and hence free cash flow. In addition, it is unlikely that Fishy Discs inventory
will decline in future periods given we are expecting growth of 12% in the near term.
Concern 2: The corporate finance firm are using a three-stage model with declining growth
after four years. The model takes six years for growth to decline to sustainable levels.
Given that Fishy Discs will lose its exclusivity agreement with the U.S. producer in four
years, it is likely that the decline in growth will be far more rapid. Once barriers to entry
are removed growth will decline from 12% to 4% far more rapidly than is being modelled.
For companies that sustain economic profit due barriers to entry such as patents,
copyrights and other agreements using a two stage model may model the decline in
growth due to an influx in competition more accurately.
How many of the FCFF definitions, in Exhibit 3, that Tony is studying are accurate?
A) Both.
B) Neither.
C) Only FCFF from EBIT.
Explanation
FCFF = EBITDA(1 – T) + (D × T) – FCINV – WCINV
Note that the formulae given in the question is incorrect as it adds back depreciation
rather than the tax shield on depreciation. It should be noted that other NCC might need
to be adjusted for in practice.
The estimate of value from FCFE models will always be different than the value obtained
using DDM, if:
A) FCFE is higher than dividends.

FCFE is greater than dividends, and the excess is not invested in zero NPV
B)
projects.
C) FCFE is higher than dividends, and the excess is invested in zero NPV projects.
Explanation
The estimate of value from FCFE models will always be different from the value obtained
using DDM, if the FCFE is greater than dividends, and the excess cash is not invested in
zero NPV projects.
Terminal value in a multi-stage free cash flow to equity (FCFE) valuation model is often
calculated as the present value of:
A) a two-stage valuation model's price.

B) free cash flow divided by the growth rate.
C) FCFE divided by the total of required rate on equity minus growth.
Explanation
Terminal values are usually calculated as the present value of the price produced by a
constant-growth model as of the beginning of the last stage, which is FCFE / (required rate
on equity – growth).
(Module 21.5, LOS 21.l)

Which of the following statements regarding the FCFF models is most accurate? The two-
stage FCFF model is more useful than the stable-growth FCFF model when the firm is
growing at a rate:
A) significantly lower than that of the overall economy.

B) not significantly higher than that of the overall economy.
C) significantly higher than that of the overall economy.
Explanation
The two-stage FCFF model is more useful in valuing a firm that is growing at a rate
significantly higher than the overall economy. Since this cannot persist indefinitely, growth
will eventually slow to a stable growth rate consistent with that of the economy.
Ignoring any costs related to financial distress, if a firm increases its financial leverage, the
value of the firm should:
increase because the weighted average cost of capital will be lower due to
A)
interest tax shields.
decrease because the required rate of return on debt is lower than that of
B)
equity.
C) increase because the FCFF will increase.
Explanation
When a firm adds leverage, its value may increase due to the tax shields on interest
expense and the generally lower cost of debt. In theory, there is an optimal capital
structure. If the amount of debt employed is greater than the optimal, the costs associated
with risk of bankruptcy or financial distress begin to outweigh the advantage of interest
tax shields.
In using FCFE models, the assumption of growth should be:
A) only consistent with the assumptions of capital spending and depreciation.

B) independent from the assumptions of other variables.
C) consistent with assumptions of other variables.
Explanation
The assumption of growth should be consistent with assumptions about other variables.
Net capital expenditures (capital expenditures minus depreciation) and beta (risk) used to
calculate required rate of return should be consistent with assumed growth rate.

An analyst has prepared the following scenarios for Schneider, Inc.:
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.
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%.
Year 0
Scenario 2 FCFF Year 1 Year 2 Year 3 Year 4
(last year)
EBIT $15.00 $17.25 $19.84 $22.81 $23.27
Depreciation 4.00 4.60 5.29 6.08
Change in Working
2.00 2.10 2.20 2.40 2.40
Capital
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:
A) increase due to the additional value of interest tax shields.

B) decline due to the increase in risk.
C) not change because financial leverage has no relationship with firm value.
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.

Assuming that the investment in fixed capital and working capital offset each other, free
cash flow to the firm (FCFF) may be proxied by net income if:
A) non-cash charges and interest charges are equal.

B) non-cash charges and interest charges are zero.
C) earnings before interest and taxes (EBIT) equals depreciation.
Explanation
The answer is shown by the relationship between FCFF and net income: FCFF = NI + NCC +
Int (1 – tax rate) – FCInv – WCInv. Further: FCFF = EBIT (1 – tax rate) + Dep – FCInv – WCInv,
which assumes that depreciation is the only non-cash charge.
Mark Washington, CFA, uses a two-stage free cash flow to equity (FCFE) discount model to
value Texas Van Lines. His analysis yields an extremely low value, which he believes is
incorrect. Which of the following is least likely to be a cause of this suspect valuation
estimate?
The forecast of working capital as a percentage of revenues in the stable growth

A)
period is not large enough to maintain the long-term sustainable growth rate.
Earnings are temporarily depressed because of a one-time extraordinary
B)
accounting charge in the most recent fiscal year.
The cost of equity estimate in the stable growth period is too high for a stable
C)
firm.
Explanation
The larger the estimate of working capital as a percentage of revenues, the larger the
investment in net working capital, and the lower the FCFE in the stable period. A low
stable-period FCFE estimate will result in a low estimate of value today. The solution is to
use a working capital ratio closer to the long-run industry average.
If the cost of equity estimate in the stable growth period is too high, the terminal value will
be too low. Because the terminal value typically makes up a large portion of the current
value, this will cause the current value estimate to be too low. The solution is to use a cost
of equity estimate based on a beta of one.
If earnings are temporarily depressed, all the FCFE estimates will be low, and the current
value estimate will be low. The solution is to use an estimate of long-run normalized
earnings.
Which of the following statements about the three-stage FCFE model is most accurate?
A) There is a transition period where the growth rate declines.

B) There is a final phase when growth rate starts to decline.
C) There is a transition period where the growth rate is stable.
Explanation
In the three-stage FCFE model, there is an initial phase of high growth, a transition period
where the growth rate declines, and a steady-state period where growth is stable.
In forecasting free cash flows it is common to assume that investment in working capital:
A) is greater than fixed capital investment during a growth phase.

B) will be financed using the target debt ratio.
C) will equal fixed capital investment.
Explanation
It is usually assumed that the investment in working capital will be financed consistent
with the target debt ratio.
The following information was collected from the financial statements of Hiller GmbH, a German consulting company,
for the year ending December 31, 2013:
Earnings per share = €4.50.

Capital Expenditures per share = €3.00.
Depreciation per share = €2.75.
Increase in working capital per share = €0.75.
Debt financing ratio = 30.0%.
Cost of equity = 12.0%.
Cost of debt = 6.0%.
Tax rate = 30.0%.
Outstanding shares = 100 million.
New debt borrowing = €15.0 million.
Debt repayment = €30.0 million.
Interest expense = €7.1 million.
The financial leverage for the firm is expected to be stable. Hiller uses IFRS accounting standards and records interest
expense as cash flow from financing (CFF).
Two analysts are valuing Hiller stock; both are basing their analysis on FCFE approaches.
Analyst #1 remarks: "Hiller is a relatively mature company; a constant growth model is the better approach."
Analyst #1 estimates FCFE based on the information above and a growth rate of 5.0%.
Analyst #2 states: "Hiller just acquired a rival that should change their growth pattern. I think a three stage growth
model based on industry growth patterns should be used."
Analyst #2 estimates FCFE per share as €3.85. Growth rate estimates are listed below, and from year 7 and thereafter
the estimated growth rate is 3.0%.
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7+
Growth rates 12.5% 12.5% 12.5% 8.0% 6.5% 5.0% 3.0%

Assuming a constant debt-to-asset ratio, the base year FCFE is closest to:
A) €3.00.
B) €3.80.
C) €4.85.
Explanation
Base-year FCFE = EPS − (capital expenditures − depreciation) × (1 − debt ratio) − increase in

working capital × (1 − debt ratio) = €4.50 − (€3.00 − €2.75)(1 − 0.30) − €0.75(1 − 0.30) =
€3.80.
Using the stable-growth FCFE model as suggested by Analyst #1, the value of Hiller stock is
closest to:
A) €51.58.
B) €54.29.
C) €57.00.
Explanation
Value per share = (€3.80 × 1.05) / (0.12 − 0.05) = €57.00.
Based on Analyst #2's estimates, the sum of the terminal value plus the FCFE for year 6 is
closest to:
A) €75.80.
B) €60.70.
C) €82.40.
Explanation
Estimates for the future FCFE based on supplied growth rates are:
Year 0 1 2 3 4 5 6 7
Growth rate 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
Terminal value year 6 = 6.818/(12.0% − 3.0%) = €75.76
The nominal cash flow for year 6 is €75.76 + €6.62 = €82.38, which is the terminal cash
flow plus the FCFE value for the year.
Based on Analyst #2's estimates, the value of Hiller stock is closest to:
A) €60.70.
B) €59.70.
C) €57.00.
Explanation
Year 0 1 2 3 4 5 6 7
Growth rate 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
Terminal value year 6 = 6.818/(12.0% − 3.0%) = €75.76
For the calculator find NPV: CF0 = 0, CF1 = €4.33, CF2 = €4.87, CF3 = €5.48, CF4 = €5.89, CF5
= €6.34, CF6 = €82.38, I/Y = 12. The result is €60.73.
Free cash flow to equity valuation uses which discount rate?
A) Cost of equity.
B) After-tax cost of debt.
C) Weighted average cost of capital.
Explanation
Free cash flow to equity valuation uses the opportunity cost relevant to stockholders,
which is the cost of equity.
Beachwood Builders merged with Country Point Homes in December 31, 1992. Both companies were builders of mid-
scale and luxury homes in their respective markets. In 2004, because of tax considerations and the need to segment
the businesses between mid-scale and luxury homes, Beachwood decided to spin-off Country Point, its luxury home
subsidiary, to its common shareholders. Beachwood retained Bernheim Securities to value the spin-off of Country
Point as of December 31, 2004.
When the books closed on 2004, Beachwood had $140 million in debt outstanding due in 2012 at a coupon rate of 8%,
a spread of 2% above the current risk free rate. Beachwood also had 5 million common shares outstanding. It pays no
dividends, has no preferred shareholders, and faces a tax rate of 30%. When valuing common stock, Bernheim's
valuation models utilize a market risk premium of 11%.
The common equity allocated to Country Point for the spin-off was $55.6 million as of December 31, 2004. There was
no long-term debt allocated from Beachwood.
The Managing Director in charge of Bernheim's construction group, Denzel Johnson, is prepping for the valuation
presentation for Beachwood's board with Cara Nguyen, one of the firm's associates. Nguyen tells Johnson that
Bernheim estimated Country Point's net income at $10 million in 2004, growing $5 million per year through 2008.
Based on Nguyen's calculations, Country Point will be worth $223.7 million at the end of 2008. Nguyen decided to use
a cost of equity for Country Point in the valuation equal to its return on equity at the end of 2004 (rounded to the
nearest percentage point).
Nguyen also gives Johnson the table she obtained from Beachwood projecting depreciation (the only non-cash charge)
and capital expenditures:
$(in millions) 2004 2005 2006 2007 2008
Depreciation 5 6 5 6 5
Capital Expenditures 7 8 9 10 12
Looking at the numbers, Johnson tells Nguyen, "Country Point's free cash flow (FCF) will be $25 million in 2006."
Nguyen adds, "That's FCF to the Firm (FCFF). FCF to Equity (FCFE) will be lower."
Regarding the statements by Johnson and Nguyen about FCF in 2006:
A) only Nguyen is incorrect.

B) only Johnson is incorrect.
C) both are incorrect.
Explanation
To estimate FCF, we can construct the following table using the table given and the
information about growth in net income:
$(in millions) 2004 2005 2006 2007 2008

Net Income 10 15 20 25 30
Plus: Depreciation 5 6 5 6 5
Less: Capital
7 8 9 10 12
Expenditures
Free Cash Flow 8 13 16 21 23
The estimated free cash flow for 2006 is $16 million. Johnson's statement is incorrect.
Since none of Beachwood's debt is allocated to Country Point, all the financing is in the
form of equity, so FCFF and FCFE are equal. Nguyen's statement is also incorrect.

If FCInv equals Fixed Capital Investment and WCInv equals Working Capital Investment,
which statement about FCF and its components is least accurate?
A) FCFE = (EBIT × (1 − tax rate)) + Depreciation − FCInv − WCInv.

B) FCFF = (EBITDA × (1 − tax rate)) + (Depreciation × tax rate) − FCInv − WCInv.
WCInv is the change in the working capital accounts, excluding cash and short-
C)
term borrowings.
Explanation
The correct version of this equation is:
FCFF = (EBIT × (1 − tax rate)) + Depreciation − FCInv − WCInv
Given Nguyen's estimate of Country Point's terminal value in 2008, what is the growth
assumption she must have used for free cash flow after 2008?
A) 3%.
B) 7%.
C) 9%.
Explanation
We know the terminal value in 2008 is $223.7 million. We can calculate the free cash flow
in 2008 to be $23 million (= $30 million net income + $5 million depreciation − $12 million
capital expenditures). (See the table in question 1). Thus, we can solve for the estimated
growth rate:
Terminal value = [CF@2008 × (growth rate + 1)] / (discount rate − growth rate)
223.7 million = ($23 million × (growth rate + 1)) / (0.18 − growth rate)
223.7 million × (0.18 − growth rate) = 23 million × (growth rate + 1)
40.266 − (223.7 × growth rate) = 23 million + (23 × growth rate)
17.266 = 246.7 × (growth rate)
growth rate = 0.07
Nguyen's growth rate assumption is 7% per year
The value of beta for Country Point is:

A) 1.27.
B) 1.00.
C) 1.09.
Explanation
The risk free rate is (8% − 2%) = 6%. We are told that the market risk premium is 11%, and
we calculated the cost of equity (required return) to be (10 million / 55.6 million =) 18%.
Since we know the risk-free rate, the market risk premium, and the discount rate, we can
use the capital asset pricing model to solve for beta:
Required rate of return = 0.18 = 0.06 + (b × 0.11)
0.18 − 0.06 = b × 0.11
0.12 = b × 0.11
b = 1.09
The following information pertains to the Harrisburg Tire Company (HTC) in 2000.
Earnings (net income) = $600M.

Dividends = $120M.
Interest expense = $400M.
Tax rate = 40%.
Depreciation = $500M.
Capital spending = $800M.
Total assets = $10B (book value and market value).
Debt = $4B (book value and market value).
Equity = $6B (book value and market value).
The firm's working capital needs are negligible, and they plan to continue to operate at their
current capital structure.
The free cash flow to the firm is:
A) $300M.
B) $420M.
C) $540M.
Explanation
The free cash flow to the firm is:
FCFF = Net income + (Interest expense)(1 − T) − Capital expenditures +

Depreciation
600M + 400M(1 − 0.40) − 800M + 500M = 540M

Currently, a firm has no outstanding debt. If the firm would add a small amount of leverage
to its balance sheet, what should be the impact on the firm's value? There would be:
A) no change in firm value.

B) an increase in value due to interest tax shields.
C) a decrease in value due to higher interest expense.
Explanation
The amount of financial leverage used by a firm will affect its value. For small amounts of
leverage, the additional bankruptcy risk will be low, and will be more than offset by the
additional value of interest tax shields.
The repurchase of 20% of a firm's outstanding common shares will cause free cash flow to
the firm (FCFF) to:
A) remain the same.

B) decrease.
C) increase.
Explanation
Share repurchases are a use of free cash flows, not a source. FCFF is cash flow that is
available to all capital suppliers. Notice the conspicuous absence of repurchases in the
following: FCFF = CFO + Int (1 – tax rate) – FCInv.

The following information is derived from the financial records of Brown Company for the
year ended December 31, 2004:
Sales $3,400,000
Cost of Goods Sold (COGS) (2,100,000)
Depreciation (300,000)
Interest Paid (200,000)
Gain on Sale of Old Equipment 400,000
Income Taxes Paid (300,000)
Net Income $900,000
Brown issued bonds on June 30, 2004 and received proceeds of $4,000,000.
Old equipment with a book value of $2,000,000 was sold on August 15, 2004 for
$2,400,000 cash.
Brown purchased land for a new factory on September 30, 2004 for $3,000,000,
issuing a $2,000,000 note and paying the balance in cash.
Cash flow from operations less capital expenditures is:
A) $200,000.
B) $6,200,000.
C) $2,200,000.
Explanation
Brown's cash flow from operations (CFO) was $800,000 = ($900,000 Net Income + $300,000
depreciation − $400,000 gain).
Capital expenditure cash flows were −$3,000,000 for the factory and $2,400,000 cash
received from sale of the old equipment for a net outflow of cash of $600,000.
$200,000 = ($800,000 - $600,000).
In what ways are dividends different from free cashflow to equity (FCFE)?
A) There is no difference. Dividends must equal FCFE.

Dividends are often viewed as "sticky." Managers are reluctant to radically
B)
change the dividend payout policy while FCFE often has immense variability.
Companies often use FCFE as a signal of positive future growth prospects while
C)
dividends are not used for signaling.
Explanation
Dividends and the FCFE are often different and dividends are used as a signal to the
market not FCFE. Dividends viewed as sticky is the true statement.

If a firm is valued using FCFF, the relevant discount rate is the:
A) after-tax weighted average cost of capital.

B) before-tax weighted average cost of capital.
C) before-tax cost of equity.
Explanation
Since the FCFF is the cash available to all the investors, the after-tax weighted average cost
of capital should be used as the discount rate in FCFF models.
The following information was collected from the financial statements of Bankers Industrial Corp (BIC) for the year
ended December 31, 2013.
Earnings before interest and taxes (EBIT) = $6.00 million.

Capital expenditures = $1.25 million.
Depreciation expense = $0.63 million.
Working capital additions = $0.59 million.
Cost of debt = 10.50%.
Cost of equity = 16.00%.
Stable growth rate for FCFF = 7.00%.
Stable growth rate for FCFE = 10.00%.
Market value of debt = $20.00 million.
Book value of debt = $22.50 million.
Outstanding shares = 500,000.
Interest expense = $2.00 million.
New Debt borrowing = $3.30 million.
Debt repayment = $2.85 million.
Growth rates for two-stage growth model for FCFE:
25.0% for Years 1-3.
6.0% for Years 4 and thereafter.
BIC is currently operating at their target debt ratio of 40.00%. The firm's tax rate is 40.00%.
The free cash flow to the firm (FCFF) for the current year is closest to:
A) $2.39 million.
B) $2.31 million.
C) $3.57 million.
Explanation
The FCFF for the current year is [$6.00m × (1 − 0.40)] + $0.63m − $1.25m − $0.59m =
$2.39m.

The estimated value of the firm is closest to:
A) $50 million.
B) $47 million.
C) $38 million.
Explanation
The value of BIC using a stable-growth FCFF model is $49.95 million, calculated as:
FCFF = [$6.00m × (1 − 0.40)] + $0.63m − $1.25m − $0.59m. = $2.39m
WACC = (0.60 × 0.16) + [0.40 × 0.105 × (1 × 0.40)] = 12.12%.
Estimated value = ($2.39m × 1.07) / (0.1212 − 0.07)= $49.95 million.
If the estimated value of the free cash to the firm (FCFF) for year 0 is $2.4 million, the value
per share of BIC stock, based on the stable growth model, is closest to:
A) $39.
B) $55.
C) $61.
Explanation
FCFE = FCFF – Interest expense × (1 − tax rate) + Net borrowing = $2.40 million – [$2.00
million × (1 − 0.40)] + $3.30 million − $2.85 million = $1.65 million.
The value of equity is: [$1.65 million × (1+0.10) ] /(0.16 − 0.10) = $30.25 million.
On a per share basis: $30.25 million/500,000 = $60.50
The current market price of BIC is $62.50 per share, and the current year's FCFE is $1.75
million. Using a two-stage growth model to find the estimated the firm's value, the current
market price BIC is most accurately described as:
A) overvalued.
B) undervalued.
C) fairly valued.
Explanation
FCFE = FCFF − Interest expense × (1 − T) + New borrowing.
Year 0 1 2 3 4
Growth rate 25.0% 25.0% 25.0% 6.0%
FCFE in mil$ $1.750 $2.188 $2.734 $3.418 $3.623
The terminal value is $3,623/(0.16 – 0.06) = $36,230 million. The calculator inputs: CF0 = 0,
CF1 = $2,188, CF2 = $2,734, CF3 = $3,418 + $36,230 = $39,648, I = 16, NPV = $29.319
million.
Per share price is $29,319,000/500,000 = $58.64. The stock appears to be overvalued at

the current market price of $62.50 per share, as our estimated value of $58.64 suggests
that the market price is too high.
A firm's free cash flow to equity (FCFE) in the most recent year is $50M and is expected to
grow at 5% per year forever. If its shareholders require a return of 12%, the value of the
firm's equity using the single-stage FCFE model is:
A) $714M.
B) $417M.
C) $750M.
Explanation
The value of the firm's equity is: $50M × 1.05 / (0.12 − 0.05) = $750M

BOX, Inc., earned $4.55 per share last year. The firm had capital expenditures of $1.75 per
share and depreciation expense of $1.05. BOX, Inc., has a target debt ratio of 0.25.
High-Growth Stable-Growth
Transitional Period
Period Period
Duration 2 Years 5 Years
Will decline 8% per

year to5% in the
Earnings growth rate 45% 5%
stable-growth
period
Growth in capital Increases by 8% per Same $ amount as

30%
expenditures year Depreciation
Increases by 13% Same $ amount as

Growth in depreciation 30%
per year Capital Expenditures
Change in working $2.25 per share in

Given Below Given Below
capital Year 8
Shareholder required
25% 15% 10%
return
Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7
Earnings per share

4.55 6.60 9.57 13.11 16.91 20.46 23.12 24.27
(EPS)
Capital expenditures 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
Change in working
0.90 1.10 1.40 1.60 1.80 2.00 2.20 2.10
capital (WC)
Free cash flow to

7.63 11.01 14.67 18.08 20.62 21.89
equity (FCFE)
What is the present value of BOX, Inc.?
A) $223.65.
B) $212.91.
C) $195.71.
Explanation
Year 1 FCFE = Earnings per share − (Capital Expenditures − Depreciation)(1 − Debt Ratio) −
(Change in working capital)(1 − Debt Ratio) = 6.60 − (2.28 − 1.37) (1 − 0.25) − (1.1)(1 − 0.25)
= 5.09.
Year 8 FCFE = Earnings per share − (Capital Expenditures − Depreciation)(1 − Debt Ratio) −
(Change in working capital)(1 − Debt Ratio) = 24.27 × 1.05 − 0 − (2.25)(1 − 0.25) = 23.79.
The Terminal Value (as of Year 7) = 23.79 / (0.10 − 0.05) = 475.80.
The value of BOX, Inc., stock would be equal to: 5.09 / 1.25 + 7.63 / 1.252 + 11.01 /
[(1.25)2(1.15)1]+ 14.67 / [(1.25)2(1.15)2] + 18.08 / [(1.25)2(1.15)3] + 20.62 / [(1.25)2(1.15)4] +
21.89 / [(1.25)2(1.15)5] + 475.80 / [(1.25)2(1.15)5] =
4.07 + 4.88 + 6.13 + 7.10 + 7.61 + 7.55 + 6.97 + 151.40 = 195.71

An increase in financial leverage will cause free cash flow to equity (FCFE) to:
A) increase in the year the borrowing occurred.

B) decrease or increase, depending on its circumstances.
C) decrease in the year the borrowing occurred.
Explanation
An increase in financial leverage will increase net borrowing and, hence, increase FCFE in
the year the borrowing occurred because: FCFE = FCFF – [interest expense] (1 – tax rate) +
net borrowing.
Optimal capital structure is the mix of debt and equity that will maximize the value of the
firm and minimize:
A) the firm's cost of capital.

B) the amount of taxable profit reported.
C) agency costs of equity.
Explanation
The optimal capital structure is the mix of debt and equity that will maximize the value of
the firm and minimize weighted average cost of capital (i.e. the firm's cost of capital or
"WACC").
Free cash flow (FCF) approaches are the best source of value when:
A) FCFs track profitability closely over the analyst's forecast horizon.

B) a firm has preferred stock.
C) a firm is paying a dividend that is higher than the industry average.
Explanation
FCF approaches are best when those flows are a good indication of a firm's profitability
over the analyst's forecast horizon.

A firm currently has sales per share of $10.00, and expects sales to grow by 25% next year.
The net profit margin is expected to be 15%. Fixed capital investment net of depreciation is
projected to be 65% of the sales increase, and working capital requirements are 15% of the
projected sales increase. Debt will finance 45% of the investments in net capital and working
capital. The company has an 11% required rate of return on equity. What is the firm's
expected free cash flow to equity (FCFE) per share next year under these assumptions?
A) $0.77.
B) $1.88.
C) $0.38.
Explanation
FCFE = net profit – NetFCInv – WCInv + DebtFin = $1.88 – $1.63 – 0.38 + 0.90 = 0.77
Sudbury Industries expects FCFF in the coming year of 400 million Canadian dollars ($), and
expects FCFF to grow forever at a rate of 3 percent. The company maintains an all-equity
capital structure, and Sudbury's required rate of return on equity is 8 percent.
Sudbury Industries has 100 million outstanding common shares. Sudbury's common shares
are currently trading in the market for $80 per share.
Using the Constant-Growth FCFF Valuation Model, Sudbury's stock is:
A) overvalued.
B) undervalued.
C) fairly valued.
Explanation
Based on a free cash flow valuation model, Sudbury Industries shares appear to be fairly
valued.
Since Sudbury is an all-equity firm, WACC is the same as the required return on equity of
8%.
The firm value of Sudbury Industries is the present value of FCFF discounted by using
WACC. Since FCFF should grow at a constant 3 percent rate, the result is:
Firm value = FCFF1 / WACC−g = 400 million / 0.08−0.03 = 400 million / 0.05 =
$8,000 million
Since the firm has no debt, equity value is equal to the value of the firm. Dividing the
$8,000 million equity value by the number of outstanding shares gives the estimated value
per share:
V0 = $8,000 million / 100 million shares = $80.00 per share
A control perspective is most consistent with which of the following valuation approaches?
A) Price to enterprise value.
B) Dividends.
C) Free cash flow (FCF).
Explanation
Dividend policy can be changed by the buyer of a firm. Thus, the FCF perspective looks to
the source of dividends in a position of control rather than directly at dividends. The price
to enterprise value approach does not focus on cash flows.
Valuation with free cash flow to equity and free cash flow to the firm:
A) both use the cost of equity.

B) use different discount rates.
C) both use the after-tax cost of debt.
Explanation
Free cash flow to the firm uses the weighted average cost of capital and free cash flow to
equity uses the cost of equity. The key is to use a discount rate that reflects the
opportunity cost of the indicated investor group.

SOX, Inc., expects high growth in the next 4 years before slowing to a stable future growth of
3%. The firm is assumed to pay no dividends in the near future and has the following
forecasted free cash flow to equity (FCFE) information on a per share basis in the high-
growth period:
Year 1 Year 2 Year 3 Year 4
FCFE $3.05 $4.10 $5.24 $6.71
High-growth period assumptions:
SOX, Inc.'s, target debt ratio is 40% and a beta of 1.3.

The long-term Treasury Bond Rate is 4.0%, and the expected equity risk premium is
6%.
Stable-growth period assumptions:
SOX, Inc.'s, target debt ratio is 40% and a beta of 1.0.

The long-term Treasury Bond Rate is 4.0% and the expected equity risk premium is
6%.
Capital expenditures are assumed to equal depreciation.
In year 5, earnings are $8.10 per share while the change in working capital is $2.00 per
share.
Earnings and working capital are expected to grow by 3% a year in the future.
What is the present value on a per share basis for SOX, Inc.?
A) $70.49.
B) $77.15.
C) $64.24.
Explanation
The required rate of return in the high-growth period is (r) = 0.04 + 1.3(0.06) = 0.118.
The required rate of return in the stable-growth period is (r) = 0.04 + 1.0(0.06) = 0.10.
The Present Value (PV) of the FCFE in the high-growth period is (3.05 / 1.118) + (4.10 /
1.1182) + (5.24 / 1.1183) + (6.71 / 1.1184) = 14.06.
The Terminal Price = Expected FCFEn + 1 / (r − gn) with FCFEn + 1 = FCFE in year 5 =Earnings
per share − (Capital Expenditures − Depreciation)(1 − Debt Ratio) − (Change in working capital)(1 − Debt
Ratio) = 8.10 − 0(1 − 0.4) − 2.00(1 − 0.4) = 6.90.
The Terminal Price = 6.90 / (0.10 − 0.03) = 98.57.
The PV of the Terminal Price = (98.57 / 1.1184) = 63.09.
The value of a share today is the PV of the FCFE in the high-growth period plus the PV of
the Terminal Price = 14.06 + 63.09 = 77.15.
The difference between the value estimate produced by the dividend discount model (DDM)
and the one produced by the free cash flow to equity (FCFE) model can be accounted for by
which of the following?
A) Different estimates of model risk.
B) Different sales forecast.
C) The value in controlling the firm's dividend policy.
Explanation
The difference between the value estimate produced by the DDM and the one produced
by the FCFE model can be interpreted as the value of controlling the firm's dividend policy.
Which of the following types of companies is the two-stage free cash flow to equity (FCFE)
model best suited for? Companies:
growing at a rate similar to or less than the nominal growth rate of the
A)
economy.
B) with patents or firms in an industry with significant barriers to entry.
in high growth industries that will face increasing competitive pressures over
C)
time, leading to a gradual decline in growth to a stable level.
Explanation
The two-stage model is best suited to analyzing firms in a high growth phase that will
industry with significant barriers to entry. Companies growing at a rate similar to or less
than the nominal growth rate of the economy are best suited for the single-stage FCFE
Model. Companies in high growth industries correspond to the three-Stage FCFE Model.
Harrisburg Tire Company (HTC) forecasts the following for 2013:
Earnings (net income) = $600M.

Dividends = $120M.
Interest expense = $400M.
Tax rate = 40.0%.
Depreciation = $500M.
Capital spending = $800M.
Total assets = $10B (book value and market value).
Debt = $4B (book value and market value).
Equity = $6B (book value and market value).
Target debt to asset ratio = 0.40.
Shares outstanding = 2.0 billion
The firm's working capital needs are negligible, and HTC plans to continue to operate with the current capital
structure. The tire industry demand is highly dependent on demand for new automobiles. Individual companies in the
industry don't have much influence on the design of automobiles and have very little ability to affect their business
environment. The demand for new automobiles is highly cyclical but demand forecast errors tend to be low.

The firm's earnings growth rate is most accurately estimated as:
A) 6.4%.
B) 8.0%.
C) 4.8%.
Explanation
The firm's estimated earnings growth rate is the product of its retention ratio and ROE:
g = RR × (ROE) = [(600 − 120) / 600] × (600 / 6000) = 0.08
The 2013 forecasted free cash flow to equity is:
A) $300M.
B) $340M.
C) $420M.
Explanation
Since working capital needs are negligible, the free cash flow to equity is:
FCFE = Net income − [1 − DR)] × [FCInv − Depreciation] − [(1 − DR) × WCInv]
FCFE = 600M − [1 − 0.4] × (800M − 500M) = 420M
where:
DR = target debt to asset ratio
If the total market value of equity is $6.0 billion and the growth rate is 8.0%, the cost of
equity based on the stable growth FCFE model is closest to:
A) 7.0%.
B) 15.0%.
C) 14.0%.
Explanation
Value of equity = FCFE1/(Cost of equity – growth rate); so $6,000 = [$420/(Cost of equity −
0.08)]
(Cost of equity − 0.08) × $6,000 = $420
Cost of equity − 0.08 = 0.07
Cost of equity = 0.15 = 15.0%
The beta for HTC is 1.056, the risk-free rate is 5.0% and the market risk premium is 10.0%.
The weighted average cost of capital for HTC is closest to:
A) 13.34%.
B) 15.56%.
C) 11.74%.
Explanation
Cost of equity = rf + (rm - rf) = 0.05 + 1.056(0.10) = 0.05 + 0.1056 = 0.1556
The best approximation for cost of debt is the interest expense divided by the market
value of the debt.
Cost of debt = Interest expense/market value of debt = $400 million/$4.0 billion = 0.10
WACC = wd × rd × (1 – t) + we × re = 0.40 × 0.10 × (1 – 0.40) + 0.60 × 0.1556 = 0.1174
Free cash flow to the firm valuation uses which discount rate?
A) Cost of equity.
B) After-tax cost of debt.
C) Weighted average cost of capital.
Explanation
Free cash flow to the firm valuation uses the opportunity cost relevant to the overall firm,
which is the weighted average cost of capital.
Which of the following free cash flow to the firm (FCFF) models is most suited to analyze
firms that are growing at a faster rate than the overall economy?
A) No growth FCFF model.
B) Two-stage FCFF model.
C) High growth FCFF model.
Explanation
The two-stage FCFF model is most suited for analyzing firms growing at a rate faster than
the overall economy. The two-stage model assumes a high rate of growth for an initial
period, followed by an immediate jump to a constant, stable growth rate.
Jon Binkster, CFA, is researching a U.S. based company Busicomb Inc., who have just released their financial
statements for the year ended December 20x5. These financial statements are included in Exhibits 1–3 below.
Exhibit 1
Busicomb Inc. Annual Income Statement
For the Year Ended December 31, 20x5 (in $ millions)
Sales 721.9
Operating expenses (417.0)
Operating profit 304.9
Gain on sale of fixed assets 9.6
Depreciation (170.8)
Earnings before interest and tax 143.7
Interest expense (40.3)
Pre-tax income 103.4
Income taxes (31.0)
Net income 72.4
Exhibit 2
Busicomb Inc. Balance Sheet
As of December 31 (in $ millions)
20x5 20x4
Current Asset
31.2 14.0
Cash and equivalents
Accounts receivable 72.0 64.8
Inventories 501.7 453.7
Total current assets 604.9 532.5
Non-Current Assets
Property, plant, and equipment 1138.7 982.7
Less: Accumulated depreciation (370.0) (216.0)
Net property, plant, and equipment 768.7 766.7
Total assets 1373.6 1299.2
Current Liabilities
60.1 62.5
Accounts payable
Notes payable 30.0 20.0
Total current liabilities 90.1 82.5
Non-Current Liabilities
576.0 588.0
Long term debt
Total liabilities 666.1 670.5
Shareholders Equity
384.0 360.0
Common equity
Retained earnings 323.5 268.7
Total equity 707.5 628.7
Total liabilities and equity 1373.6 1299.2
Exhibit 3
Busicomb Inc. Cash Flow Statement
For the Year Ended December 31, 20x5 (in $ millions)
Cash Flow from Operating Activities
Net income 72.4
Depreciation 170.8
Gain on sale of fixed assets (9.6)
Change in Working Capital
(Increase) Decrease in accounts receivable (7.2)
(Increase) Decrease in inventories (48.0)
Increase (Decrease) in accounts payable (2.4)
Net change in working capital (57.6)
Net cash from operating activities 176.0
Cash Flow from Investing Activities
Purchase of property, plant, and equipment (183.2)
Proceeds on disposal of plant and equipment 20.0
Net cash from investing activities (163.2)
12.8
Cash Flow from Financing Activities
Change in debt outstanding (2.0)
Change in common stock 24.0
Payment of cash dividend (17.6)
Net cash from financing activities 4.4

Net change in cash and cash equivalents 17.2
Cash at beginning of period 14.0
Cash at end of period 31.2
Busicomb Inc. announces a new strategic alliance that will require it to sell products on behalf of a very successful
major European manufacturing and distribution operation. Binkster decides to value Busicomb using the dividend
discount model (DDM) and the free cash flow-to-firm model (FCFF). Binkster undertakes a review of the financial
performance of Busicomb Inc. using Exhibits 1 to 3 and forecasts related to the new sales contract, Binkster reaches
the following conclusions:
Earnings are expected to grow at 18%, next year before stabilizing to a long-term growth rate of 6% after six
years (i.e., year 6). You can assume that the growth rate declines evenly each year between the high growth and
the low growth period.
The current payout ratio will be maintained, and the firm has a long-term target debt to capital ratio of 50%.
Busicomb Inc. has an equity beta of 1.3.
Government bond yield is 4.5% and the market equity risk premium is 6%.
There are 12 million shares outstanding.
The market value of the debt in the balance sheet of Busicomb Inc. is not materially different from the book
value.
The required rate of return of the debt holders is 7%.
The effective tax rate of Busicomb is 30%.
Using the three components of the DuPont system, and using opening balance sheet values,
which of the following statements regarding 20x5 is correct?
A) Total asset turnover is 0.556, financial leverage is 2.07, and ROE is 11.5%.
B) Total asset turnover is 1.798, financial leverage is 2.07, and ROE is 11.5%.
C) Total asset turnover is 0.556, financial leverage is 0.483, and ROE is 11.5%.
Explanation
ROE using the DuPont three component approach:
ROE = profit margin × asset turnover × financial leverage

profit sales assets
= × ×
sales assets equity
72.4 721.9 1299.2

= × ×
721.9 1299.2 628.7
= 0.100 × 0.556 × 2.066 = 0.1149 = 11.5%
Note that it is typical to compute ROE based on opening equity for valuation contexts,
whilst in FRA we typically use average values. The CFA Institute curriculum does note that
some analyst compute ROE in a valuation context using average balance sheet values so
care should be taken to follow the instructions in the question whether to use opening or
average values.
(Module 20.3, LOS 20.p)

Assuming an ROE on 11.5%, which of the following is the best estimate of the sustainable
growth rate for Busicomb Inc.?
A) 10.1%.
B) 8.7%.
C) 11.5%.
Explanation
Sustainable growth rate:
g = ROE × earnings retention rate
g = 11.54% × (1 – (17.6 / 72.4)) = 11.54% × 0.757 = 8.736%
(Module 20.3, LOS 20.p)
Which of the following is the most accurate estimate of the value of a share of Busicomb
Inc.'s common stock using the H model variant of the dividend discount model (DDM)? Work
to the nearest $ and assume the cost of equity is 12.3%.
A) $33 per share.

B) $32 per share.
C) $42 per share.
Explanation
Cost of equity = Rf + β(Rm – Rf)
= 4.5% + 1.3(6%) = 12.3%
Using the H model:
Dividend = 17.6m / 12m = $1.47
D0 (1+g ) D0 ×H(g -g )
l h l
MV0 = +
k-g k-g
l l
6
1.47(1+0.06) 1.47× (0.18−0.06)
2
MV0 = +
(0.123−0.06) (0.123−0.06)
MV = $24.73 + $8.40
MV = $33.13
(Module 20.3, LOS 20.n)

It has also been estimated that the Free Cash Flow to the firm will be $46m next year. It is
expected to grow at 12% for the following two years before settling down to a long-term rate
of growth of 6%. Which of the following is the most accurate estimate of the value of
Busicomb Inc.'s business using a two stage FCFF model? Work to the nearest $m.
A) $2,402m.
B) $2,204m.
C) $1,968m.
Explanation
Using a two stage model:
FCFF1 = $46m
WACC = (12.3% × 0.5) + (7 × (1 – 0.3) × 0.5) = 8.6%

2 2
46(1.12) 46(1.12) 46(1.12) (1.06)
46
MVfirm = + + +
1 2 3 3
(1.086) (1.086) (1.086) (0.086−0.06)(1.086)
MVfirm = 42.36 + 43.68 + 45.05 + 1,836.69
MVfirm = 1967.78
Michael Patrick, CFA, is a new analyst at EKS Inc., an investment management company based in New York. Patrick is
attempting to value Johan Corp., a U.S. based company using free cash flows. Exhibits 1 through 2 present extracts
from the financial statements, which are prepared according to U.S. GAAP.
Exhibit 1
Johan Corp.
Summary Balance Sheets on 31 December (U.S. $ millions)
2x12 Forecast 2x11 Actual
Cash 50 40
Accounts receivable 220 200
Inventory 265 245
Current assets 535 485
Gross PP&E 2,000 1,600
Accumulated depreciation (950) (890)
Total assets 1,585 1,195

Accounts payable 50 50
Short-term debt 70 50
Current liabilities 120 100
Long-term debt 620 400
Common stock 335 335
Retained earnings 510 360
Total liabilities and equity 1,585 1,195
Exhibit 2
Johan Corp.
Summary Income Statement (U.S. $ millions)
2x12 Forecast 2x11 Actual
EBIT 415 380
EBITDA 475 430
Interest expense 200 180
Tax rate = 30%
There will be no sales of long-term assets in 2x12.
Patrick who is unfamiliar with the free cash flow technique has been reviewing EKS's handbook for some guidance.
The statements below are extracts from the handbook:
Statement Share repurchases will reduce FCFE and will leave FCFF unchanged.
1:
Statement Changes in leverage have a minor effect on FCFE and no effect on FCFF. For example, decreasing
2: leverage through repayment of debt will decrease FCFE in the current year and increase forecasted
FCFE in future years.
Statement The loss on a sale of a long-term asset that has been included in operating expenses is a non-cash
3: charge that should be adjusted for when calculating FCFF from EBIT.
Statement The formula to calculate FCFF based on EBITDA is: FCFF = EBITDA(1 – tax rate) – FCInv – WCInv
4:
Patrick is also looking to value a potential takeover target, Fite Inc. Patrick has gathered the following data on Fite Inc.
All figures are in millions of dollars.
2x11 2x10 2x09 2x08
Net income –$12 $110 $50 $95
FCFE –$5 –$35 $45 –$20
FCFF $9 $11 $12 $14
Dividends $10 $10 $9 $9
Debt-to-equity 97% 94% 81% 85%
Patrick decides to use the most recent 2x11 FCFF of $9 to estimate the value of the firm. He decides to use a three-
stage model and makes the following assumptions:
High growth phase: FCFF will grow at 30% for the next three years. WACC = 18%
For the following 3 years, growth will decline by 8% per year down to a stable growth rate of
Transitional phase:
6%. WACC = 15%
Stable-growth
Growth will remain at 6% forever. WACC = 10%
period:
Calculate the forecasted free cash flow to the firm (FCFF) for 2x12, using the data in Exhibits
1 and 2.
A) –89.5.
B) –107.5.
C) –131.5.
Explanation
FCFF = EBIT × (1 – tax rate) + dep – FCINV– WCINV
FCFF = 415 × (1 – 0.30) + 60 – 400 – 40 = –89.5
Alternatively:
FCFF = [EBITDA × (1 – tax rate)] + (dep × tax rate) – FCINV – WCINV
FCFF = [475 × (1 – 0.30)] + (60 × 0.30) – 400 – 40 = –89.5
Depreciation:
Accumulated depreciation 31 December 2011 = $890
Accumulated depreciation 31 December 2012 = $950
With no asset sales during the period the depreciation charge for 2012 = $60
Fixed capital investment:
This is equal to capital expenditures (because there are no asset sales), which is equal to
the change in gross PP&E:
FCINV = 2000 – 1600 = 400
Working capital investment:
This is the change in the working capital accounts, excluding cash and short-term
borrowings.
Working capital = receivables + inventory – payables
WCINV = (220 + 265 – 50) – (200 + 245 – 50) = 40
Calculate the forecasted free cash flow to equity (FCFE) for 2x12.
A) 10.5.
B) –9.5.
C) –49.5.
Explanation
FCFE = FCFF – Int (1 – tax rate) + net borrowing
FCFE = –89.5 – 200(1 – 0.3) + 240 = 10.5
Net borrowing is the difference between the long-term and short-term debt accounts (the
impact caused by amortization of premiums and discounts should be removed if debt is
not issued at par):
= (620 + 70) – (400 + 50) = 240
Alternatively:
FCFE = NI + dep – FCINV – WCINV + net borrowing
= [(415 – 200) × 0.7] + 60 – 400 – 40 + 240 = 10.5

Regarding the handbook's statements on free cash flow techniques:
Statement 1 Statement 2
A) Correct Correct
B) Incorrect Correct
C) Correct Incorrect
Explanation
Dividends, share repurchases, and share issues have no effect on either FCFF or FCFE.
FCFF and FCFE represent the total cash flow available before financing decisions. Share
repurchases represent uses of those cash flows.
If debt is repaid FCFE, will decrease in the current year because of reduced (negative) net
borrowings and will increase in future years as interest expense is reduced.
Regarding the handbook's statements on free cash flow techniques:
Statement 3 Statement 4
A) Correct Correct
B) Incorrect Correct
C) Correct Incorrect
Explanation
FCFF = [EBIT × (1 – tax rate)] + dep – FCINV – WCINV
We assume that the only non-cash charge that appears above EBIT is depreciation. In
general however the rule is to adjust for any non-cash charges that appear above EBIT.
FCFF = [EBITDA × (1 – tax rate)] + (dep × tax rate) – FCINV – WCINV
The most appropriate model for valuing Fite Inc. is the:
A) free cash flow to equity model.

B) free cash flow to the firm model.
C) dividend discount H-model.
Explanation
A dividend discount model is inappropriate, as dividends are not related to the earnings
stream. In addition, as this is a takeover situation a free cash flow approach is more
suitable as the acquirer has control and discretion over the distribution of the total free
cash flow. With dividend discount models a minority, interest is assumed (i.e., no control
over dividend policy).
FCFF model is preferred to FCFE as FCFE is negative and volatile and leverage is high.
Assuming Patrick is correct to use free cash flow to the firm to value Fite Inc.; the value of
the firm is closest to:
A) 379.
B) 412.
C) 22.
Explanation
High Growth Period Year 1 Year 2 Year 3
Growth rate 30% 30% 30%
FCFF 11.7 15.21 19.773
PV(@18%) 9.915 10.924 12.034
Transitional
Year 4 Year 5 Year 6
Period
Growth rate 22% 14% 6%
FCFF 24.123 27.500 29.150
1 1 1
∗ ∗ ∗
3 2 3 3 3
PV(@18%/15%) 1.15∗1.18 1.15 ∗1.18 1.15 ∗1.18
= 12.767 = 12.656 =11.666
Terminal value as of Year 6 using the FCFF projected for Year 7.
Terminal value = 29.150 (1.06) / (0.10 – 0.06) = 772.48
PV of terminal value = 772.48 / (1.153 × 1.183) = 309.135
Value of the firm = 9.915 + 10.924 + 12.034 + 12.767 + 12.656 + 11.666 + 309.135 = 379

Michael Ballmer is an equity analyst with New Horizon Research. The firm has historically relied on dividend and
residual income valuation models to value equity, but the firm's director of research, Doug Leads, has decided that
the firm needs to incorporate free cash flow valuations into its practices. Therefore, Leads decides to send Ballmer to
a seminar on free cash flow valuation.
Upon his return from the convention, Ballmer is excited to share his newfound knowledge with his co-workers.
Ballmer is asked to give a debriefing to New Horizon's team of equity analysts, where he makes the following
statements:
Free cash flow to the firm is the amount of the firm's cash flow that is free for the firm to
Statement 1:
use in making investments after cash operating expenses have been covered.
Free cash flow to equity, then, is the amount of the firm's cash flow that is free for equity
holders after covering cash operating expenses, working capital and fixed capital
Statement 2:
investments, interest principal payments to bondholders, and required divided
payments.
After discussing the calculation of free cash flow to the firm and free cash flow to equity from historical information,
Ballmer proceeds to explain the major approaches for forecasting free cash flow. He focuses his discussion on
forecasting the components of free cash flow as this method is more flexible. During his presentation, several of the
analysts notice that the formula for forecasting free cash flow to equity does not include net borrowing. They bring
this to Ballmer's attention, and he states that he will look into the formula and send out an updated presentation after
the meeting.
A week after the meeting, Jonathan Hodges approached Ballmer regarding two issues he had while applying free cash
flow based valuations. The first issue that Hodges had was that he calculated the equity value of a firm using both free
cash flow to equity based and dividend-based valuations and arrived at different values. The second issue that
Hodges came across was the effect of a change in a firm's target leverage on FCFE. One of the firms that Hodges was
analyzing may reduce leverage, and Hodges needs to know if this will affect his valuation.
Regarding statements 1 and 2, are Ballmer's interpretations of free cash flow to the firm
(FCFF) and free cash flow to equity (FCFE) CORRECT?
A) No, only one interpretation is correct.

B) Yes, both interpretations are correct.
C) No, neither interpretation is correct.
Explanation
Free cash flow to the firm (FCFF) is the cash flows that are free to investors after cash
operating expenses (including taxes but excluding interest expense), working capital
investments, and fixed capital investments have been made. Free cash flow to equity
(FCFE) is FCFF less interest payments to bondholders and net borrowing from
bondholders.
Which of the following statements regarding forecasting FCFE using the components of free
cash flow method and net borrowing is most accurate?
Net income already accounts for interest expense; therefore, net borrowing is
A)
not needed.
B) Investment in fixed capital and net borrowing are assumed to offset each other.
The target debt-to-asset ratio accounts for the financing of new investment in
C)
fixed capital and working capital.
Explanation
When forecasting FCFE, it is common to assume that a firm will maintain a target debt-to-
asset ratio for new investments in fixed capital and working capital. Based on this
assumption, the formula for forecasting FCFE is:
FCFE = NI − [(1 − DR) × (FCInv − Dep)] − [(1 − DR) × WCInv]
By multiplying the fixed capital and working capital investments by one minus the target
debt-to-asset ratio, you are left with the investment amount less the amount financed by
debt, which is the net borrowing amount. Therefore, this formula accounts for net
borrowing through the target debt-to-asset ratio.
Should dividend-based and free cash flow from equity (FCFE) based valuations result in
different equity values for a firm?
Yes, dividend-based valuations would be higher for firms with large, consistent
A)
dividends.
B) No, both models should result in the same value.
Yes, the free cash flow from equity valuation would be higher if there were a
C)
premium associated with control of the firm.
Explanation
The ownership perspectives of dividend-based and FCFE based valuations are different.
Dividend-based valuations take the perspective of minority shareholders, while FCFE
based valuations take the perspective of an acquirer who will assume a controlling
position in the firm. If investors were willing to pay a premium for a controlling position in
the firm, then the equity value computed under the FCFE approach would be higher.
Which of the following statements regarding the effect a decrease in leverage has on a firm's
free cash flow from equity (FCFE) is most accurate?
A) Current year FCFE decreases, but future FCFE will be increased.

B) FCFE is unaffected by changes in leverage.
C) Current year FCFE increases, but future FCFE will be reduced.
Explanation
Changes in leverage do have a small effect on FCFE. A decrease in leverage will cause the
current year FCFE to decrease through the repayment of debt. Future FCFE will be
increased because interest expense will be lower.
When using the two-stage FCFE model, if increases in working capital appear too high the
analyst should:
A) switch to a three-stage model.

use changes that are based upon a working capital ratio that is closer to the
B)
industry average.
C) normalize them to be equal to zero.
Explanation
The best solution is to use changes that are based upon a working capital ratio that
approximates the industry average. The problem will not be eliminated by switching to a
three-stage FCFE model.
Terminal value in multi-stage free cash flow valuation models is often calculated as the
present value of:
A) a two-stage valuation model's price.

B) free cash flow divided by the growth rate.
C) a constant growth model's price as of the beginning of the last stage.
Explanation
Terminal values are usually calculated as the present value of the price produced by a
constant-growth model as of the beginning of the last stage.
If the investment in fixed capital and working capital offset each other, free cash flow to the
firm (FCFF) may be proxied by:
A) earnings before interest and taxes (EBIT).

B) net income plus non-cash charges plus after-tax interest.
C) net income plus after-tax interest.
Explanation
The answer is indicated by the definition of FCFF: FCFF = NI + NCC + Int (1 – tax rate) –
FCInv – WCInv. The relationship between net income and FCFF is indicated by: NI = EBIT (1
– tax rate) – Int (1 – tax rate).
An analyst is performing an equity valuation for a minority equity position in a dividend

paying multinational. The appropriate model for this analysis is most likely:
A) FCFF approach.
B) FCFE approach.
C) The Dividend Discount approach.
Explanation
The dividend discount model is most appropriate for valuing a minority equity position in
a dividend-paying company. The free cash flow approach looks to the source of dividends
from the perspective of an owner that has control rather than directly at dividends.
The value of stock under the two-stage FCFE model will be equal to:
present value (PV) of FCFE during the extraordinary growth period plus the
A)
terminal value.
present value (PV) of FCFE during the extraordinary growth and transitional
B)
periods plus the PV of terminal value.
present value (PV) of FCFE during the extraordinary growth period plus the PV of
C)
terminal value.
Explanation
The value of stock under the two-stage FCFE model will be equal to the present value of
FCFE during the extraordinary growth period plus the present value of the terminal value
at the end of this period.
In the two-stage FCFE model, the required rate of return for calculating terminal value
should be:
A) lower than the required rate of return used for the high-growth phase.
B) higher than the required rate of return used for the high-growth phase.
C) equal to the average required rate of return for the industry.
Explanation
In most cases, the required rate of return used to calculate the terminal value should be
lower than the required rate of return used for initial high-growth phase. During the stable
period the firm is less risky and the required rate of return is therefore lower.
A three-stage free cash flow to the firm (FCFF) is typically appropriate when:
growth is currently low and will move through a transitional stage to a final
A)
stage wherein growth exceeds the required rate of return.
growth is currently high and will move through a transitional stage to a steady-
B)
state growth rate.
C) the required rate of return is less than the growth rate in the last stage.
Explanation
The three-stage model using either FCFE or FCFF typically assumes that growth is currently
high and will move through a transitional stage to a steady-state growth rate. Multi-stage
models assume that the required rate of return exceeds the growth rate in the last stage.
A firm has:
Free cash flow to the firm = $4.0 million.

Weighted average cost of capital = 10%.
Total debt = $30.0 million.
Value of the firm = $50.00 per share.
What will happen to the value of the firm if the weighted average cost of capital increases to
12%?

B) The value will decrease.
C) The value will remain the same.
Explanation
Everything else being constant, an increase in the relevant required rate of return should
decrease the value of the firm.

Industrial Light currently has:

What is the value of equity?
A) $57,142,857.
B) $27,142,857.
C) $60,000,000.
Explanation
The value of equity is [($4,000,000)(1.05) / (0.12 – 0.05)] = $60,000,000.
The difference between free cash flow to equity (FCFE) and free cash flow to the firm (FCFF)
is:
A) after-tax interest and net borrowing.

B) earnings before interest and taxes (EBIT) less taxes.
C) before-tax interest and net borrowing.
Explanation
FCFE = FCFF – [interest expense] (1 – tax rate) + net borrowing.
A firm has:

Value of equity per share = $57.14 per share.
What will happen to the value of equity if the cost of equity decreases to 10%?

B) The value will decrease.
C) There is insufficient information to tell.
Explanation
Everything else being constant, a decrease in the relevant required rate of return should
increase the value of the equity per share.
A firm currently has the following per share values:
Cash flow from operations (CFO) is $49.50.

Investment in fixed capital is $40.00.
Net borrowing is $7.50.
What is the current per share free cash flow to equity (FCFE)?
A) $16.50.
B) $97.00.
C) $17.00.
Explanation
FCFE = CFO − FCInv + net borrowing = $49.50 − $40.00 + $7.50 = $17.00
A common approach to forecasting free cash flows is to:
A) project net income and expected capital expenditures.

project earnings before interest and taxes (EBIT) and expected capital
B)
expenditures.
C) calculate historical free cash flow and apply an expected growth rate.
Explanation
Historical free cash flows are often used for forecasting.

The following table provides forecasts for next year on a per share basis for TOY Inc.:
Item Forecast
Earnings $5.00
Capital Expenditures $2.40
Depreciation $1.80
Change in Working Capital $1.70
TOY Inc.'s target debt ratio is 30% and has a required rate of return of 12%. Earnings, capital
expenditures, depreciation, and working capital are all expected to grow by 5% a year in the
future. Assume that capital expenditures and working capital are financed at the target debt
ratio.
What is the forecasted free cashflow to equity (FCFE) for TOY Inc.?
A) $4.31.
B) $2.70.
C) $3.39.
Explanation
FCFE = Earnings per share − (Capital Expenditures − Depreciation) (1 − Debt Ratio) −

Change in working capital (1 − Debt Ratio) = 5.00 − (2.40 − 1.80)(1 − 0.3) − (1.7)(1 − 0.3) =
3.39.
The repayment of a significant amount of outstanding debt will cause free cash flow to
equity (FCFE) to:
A) remain the same.

B) increase.
C) decrease.
Explanation
Debt repayment will decrease net borrowing and, hence, decrease FCFE because: FCFE =
FCFF – [interest expense] (1 – tax rate) + net borrowing.
In five years, a firm is expected to be operating in a stage of its life cycle wherein its
expected growth rate is 5%, indefinitely; its required rate of return on equity is 11%; its
weighted average cost of capital is 9%; and the free cash flow to equity in year 6 will be $5.25
per share. What is its projected terminal value at the end of year 5?
A) $51.93.
B) $87.50.
C) $131.25.
Explanation
Terminal value = FCFE / (k − g) = $5.25 / (0.11 − 0.05) = $87.50
A firm's free cash flow to the firm (FCFF) in the most recent year is $80M and is expected to
grow at 3% per year forever. If the firm has $100M in debt financing and its weighted
average cost of capital is 10%. The value of the firm's equity using the single-stage FCFF
model is:
A) $1,177M.
B) $1,077M.
C) $1,043M.
Explanation
The value of the firm's equity is equal to the value of the firm minus the value of the debt.
Firm value = $80M × 1.03 / (0.10 − 0.03) = $1,177M, so equity value is $1,177M − $100M =
$1,077M.
A firm in stable growth phase should have:
a required rate of return close to the market rate of return and capital
A)
expenditures that are not too large relative to depreciation expense.
B) capital expenditures that are less than the depreciation expense.
a growth rate higher than that of the economy and a required rate of return
C)
that is greater than the market rate of return.
Explanation
A firm that is in a stable growth phase should have growth rate close to that of the
economy, and the cost of equity should approximate the required rate of return on the
market. In addition, the capital expenditures should not be disproportionately large
relative to the depreciation expense.

Industrial Light currently has:
Expected free cash flow to the firm in one year = $4.0 million.
What is the value of equity?
A) $50,000,000.
B) $80,000,000.
C) $44,440,000.
Explanation
The overall value of the firm is $4,000,000 / (0.10 – 0.05) = $80,000,000. Thus, the value of
equity is $80,000,000 – $30,000,000 = $50,000,000.

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Question #1 of 137 Question ID: 1472946

A) return on assets is falling.

(Module 21.1, LOS 21.a)

Question #2 of 137 Question ID: 1473008

A) have capital expenditures that are significantly higher than depreciation.

(Module 21.5, LOS 21.j)

Question #3 of 137 Question ID: 1473009

A) Two-stage free cash flow to the firm (FCFF) model.

(Module 21.5, LOS 21.j)

A) higher than depreciation in the stable-growth phase.

(Module 21.1, LOS 21.a)

Overhaul Trucking, Inc.

April 30, 2005

Sales 300.0 320.0

Gross Profit 200.0 190.0

SG&A 50.0 50.0

Depreciation 70.0 80.0

EBIT 80.0 60.0

Interest Expense 30.0 34.0

Taxes (at 35 percent) 17.5 9.1

Net Income 32.5 16.9

Overhaul Trucking, Inc.

April 30, 2005

Cash 10.0 15.0

Accounts Receivable 50.0 55.0

Gross Property, Plant & Equip. 400.0 480.0

Accumulated Depreciation (160.0) (240.0)

Total Assets 300.0 310.0

Accounts Payable 50.0 70.0

Long-Term Debt 140.0 113.1

Common Stock 80.0 80.0

Retained Earnings 30.0 46.9

Total Liabilities & Equity 300.0 310.0

Question #5 - 8 of 137 Question ID: 1473065

(Module 21.5, LOS 21.i)

Question #6 - 8 of 137 Question ID: 1473066

A) Overhaul’s capital structure is stable.

(Module 21.5, LOS 21.i)

Question #7 - 8 of 137 Question ID: 1473067

= 16.9 + 80 + [34 × (1 − 0.35)] − (480 − 400) − [(55 − 70) − (50 − 50)]

= 16.9 + 80 + 22.1 − 80 − (−15) = 54

Firm Value = FCFF1 / (WACC − g)

(Module 21.5, LOS 21.i)

Question #8 - 8 of 137 Question ID: 1473068

Where: DR = target debt to asset ratio

= 16.9 − (0.64 × 0) − (0.64 × (−15))

= 16.9 + 0 + 9.6 = 26.5

(Module 21.5, LOS 21.i)

Question #9 of 137 Question ID: 1472973

In forecasting free cash flows it is most common to assume that:

A) historical levels of free cash flow will persist.

(Module 21.5, LOS 21.e)

Question #10 of 137 Question ID: 1472964

A) minus after-tax interest expense.

(Module 21.2, LOS 21.c)

Question #11 of 137 Question ID: 1472986

Dividends paid out to the shareholders:

A) may be higher than free cash flow to equity FCFE.

(Module 21.5, LOS 21.f)

Question #12 of 137 Question ID: 1473003