LOS h: Explain how dividends, share repurchases, share issues, and changes in leverage may affect FCFF and FCFE.

Q1. Optimal capital structure is the mix of debt and equity that will maximize the value of the firm and minimize:

A)   interest expense.

B)   weighted average cost of equity.

C)   weighted average cost of capital (WACC).

Q2. The repayment of a significant amount of outstanding debt will cause free cash flow to equity (FCFE) to:

A)   increase.

B)   remain the same.

C)   decrease.

Q3. An increase in financial leverage will cause free cash flow to equity (FCFE) to:

A)   decrease in the year the borrowing occurred.

B)   increase in the year the borrowing occurred.

C)   decrease or increase, depending on its circumstances.

Q4. 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)   increase.

C)   decrease.

Q5. Which of the following statements is FALSE? A firm’s free cash flows to equity (FCFE) is the cash available to stockholders after funding:

A)   dividend payments.

B)   capital expenditure requirements.

C)   debt principal repayments.

Q6. An analyst has prepared the following scenarios for Schneider, Inc.:

Scenario 1 Assumptions:

• Tax rate is 40%.
• Weighted average cost of capital (WACC) = 12%.
• Constant growth rate in free cash flow = 3%.
• Last year, free cash flow to the firm (FCFF) = $30.
• Target debt ratio = 10%.

Scenario 2 Assumptions:

• Tax rate is 40%.
• Expenses before interest and taxes (EBIT), capital expenditures, and depreciation will grow at 15% for the next three years.
• After three years, the growth in EBIT will be 2%, and capital expenditure and depreciation will offset each other.
• WACC during high growth stage = 20%.
• WACC during stable growth stage = 12%.
• Target debt ratio = 10%.

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)   not change because financial leverage has no relationship with firm value.

C)   decline due to the increase in risk.

Q7. 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)   a decrease in value due to higher interest expense.

B)   an increase in value due to interest tax shields.

C)   no change in firm value.

Q8. In what ways are dividends different from free cashflow to equity (FCFE)?

A)   Companies often use FCFE as a signal of positive future growth prospects while dividends are not used for signaling.

B)   There is no difference. Dividends must equal FCFE.

C)   Dividends are often viewed as "sticky." Mangers are reluctant to radically change the dividend payout policy while FCFE often has immense variability.

Q9. Which of the following statements regarding dividends and free cash flow to equity (FCFE) is least accurate?

A)   FCFE discount models usually result in higher equity values than do dividend discount models (DDMs).

B)   FCFE can be negative but dividends cannot.

C)   Required returns are higher in FCFE discount models than they are in dividend discount models, since FCFE is more difficult to estimate.

Q10. Dividends paid out to the shareholders:

A)   are always equal to free cash flow to equity (FCFE).

B)   are always less than free cash flow to equity (FCFE).

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

Q11. Which of the following is least likely to change as the firm changes leverage?

A)   Free cash flows to equity (FCFE).

B)   Free cash flows to firm (FCFF).

C)   Weighted average cost of capital (WACC).

Q12. Ignoring any costs related to financial distress, if a firm increases its financial leverage, the value of the firm should:

A)   increase because the weighted average cost of capital will be lower due to interest tax shields.

B)   increase because the FCFF will increase.

C)   decrease because the required rate of return on debt is lower than that of equity.

GOOD

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