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LOS i: Discuss the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models, and select and justify the appropriate model given a company's characteristics.

Which of the following types of companies is the two-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.

B)	growing at a rate similar to or less than the nominal growth rate of the economy.

C)	in high growth industries 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 single-stage FCFE Model. Companies in high growth industries correspond to the three-Stage FCFE Model.

A)	the required rate of return is less than the growth rate in the last stage.

B)	growth is currently high and will move through a transitional stage to a steady-state growth rate.

C)	growth is currently low and will move through a transitional stage to a final stage wherein growth exceeds the required rate of return.

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.

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)	in high growth industries that will face increasing competitive pressures over time, leading to a gradual decline in growth to a stable level.

B)	with patents or firms in an industry with significant barriers to entry.

C)	growing at a rate similar to or less than the nominal growth rate of the economy.

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.

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.

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)	a growth rate higher than that of the economy and a required rate of return that is greater than the market rate of return.

B)	capital expenditures that are less than the depreciation expense.

C)	a required rate of return close to the market rate of return and capital expenditures that are not too large relative to depreciation expense.

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.

A)	consistent with assumptions of other variables.

B)	independent from the assumptions of other variables.

C)	only consistent with the assumptions of capital spending and depreciation.

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.

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 transition period where the growth rate is stable.

C)	There is a final phase when growth rate starts to decline.

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.

The stable-growth free cash flow to equity (FCFE) model is best suited for which of the following types of companies? Companies:

A)	growing at a rate similar or less than the nominal growth rate of the economy.

B)	with patents that will not expire for 20 or more years.

C)	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. 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 maintain that growth for a specific period, such as firms with patents or firms in an industry with significant barriers to entry.

A)	the growth rate in the stable-period is equal to that of GNP.

B)	the growth rate in the stable-period is too high.

C)	the growth rate in the stable-period is too low.

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.

Which of the following is most useful in analyzing firms that have high leverage and high growth?

A)	Stable-growth free cash flow to the firm (FCFF) model.

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

C)	Two-stage free cash flow to equity (FCFE) model.

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.

The stable-growth free cash flow to the firm (FCFF) model is most useful in valuing firms that:

A)	are growing at a rate significantly lower than that of the overall economy.

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

C)	have capital expenditures that are not significantly higher than depreciation.

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.

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)	significantly higher than that of the overall economy.

C)	not significantly higher than that of the overall economy.

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.

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)	Single-stage free cash flow to equity (FCFE).

B)	Two-stage dividend discount model (DDM).

C)	Two-stage free cash flow to equity (FCFE).

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)	FCFE Perpetuity Model.

B)	Stable Growth FCFE Model.

C)	Two-stage FCFE Model.

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.

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?

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.

A)	have very high but declining growth rate in the initial stage.

B)	have moderate growth in the initial phase that declines gradually to a stable rate.

C)	are in an industry with significant barriers to entry.

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.

The two-stage (stable growth) free cash flow to equity (FCFE) and free cash flow to the firm (FCFF) models typically assume:

A)	the required rate of return is less than the growth rate in the last stage.

B)	the required rate of return equals the growth rate in the last stage.

C)	a high-growth rate for n years and then a constant growth rate forever thereafter.

The two-stage model using either FCFE or FCFF typically assumes a high-growth rate for n years and then a constant growth rate forever thereafter. Multi-stage models assume that the required rate of return exceeds the growth rate in the last stage.