LOS n: Describe the characteristics of companies for which the FCFF model is preferred to the FCFE model.

Q1. Using free cash flows to the firm (FCFF) instead of free cash flows to equity (FCFE) or earnings will yield a more meaningful value for a multiple when:

A)   FCFEs are negative.

B)   earnings and FCFE are negative and the firm is highly levered.

C)   a firm is highly levered.

Q2. A firm that is currently experiencing negative free cash flow to equity (FCFE), is highly levered, and pays no dividends is a good candidate for which of the following valuation methods?

A)   Free cash flow to the firm (FCFF).

B)   Earnings Before Interest and Taxes (EBIT) discount.

C)   Dividend discount.

Q3. An analyst choosing between the free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) valuation approaches recognizes that an increase in leverage:

A)   increases FCFE by the amount of after-tax interest.

B)   does not change FCFF.

C)   reduces FCFE by the amount of the debt.

Q4. Free cash flow to the firm (FCFF) is superior to free cash flow to equity (FCFE) in valuation for firms that are:

A)   highly levered with negative free cash flow to equity.

B)   not paying dividends.

C)   unlevered.

Q5. FCFF models are more useful than FCFE models in valuing all of the following EXCEPT:

A)   firms that are making substantial changes to their capital structure.

B)   firms that undergo a leveraged buyout.

C)   firms that have retired all of their debt.

Q6. FCFF models are more suitable than FCFE models for valuing firms that are in the process of changing their capital structure for all of the following reasons EXCEPT:

A)   these firms will have negative FCFE.

B)   value of equity is small compared to the total value of the firm and is sensitive to the assumptions of growth and risk.

C)   operating earnings will not be affected by the change in capital structure.

Q7. Which types of firms are best valued using the free cashflow to the firm (FCFF) approach?

A)   Firms with significant financial leverage.

B)   Firms that are making no significant change to their capital structure.

C)   Firms that do not pay dividends.

LOS n: Describe the characteristics of companies for which the FCFF model is preferred to the FCFE model. fficeffice" />

Q1. Using free cash flows to the firm (FCFF) instead of free cash flows to equity (FCFE) or earnings will yield a more meaningful value for a multiple when:

A)   FCFEs are negative.

B)   earnings and FCFE are negative and the firm is highly levered.

C)   a firm is highly levered.

Correct answer is B)

The use of FCFF instead of FCFE and earnings will yield a more meaningful result when FCFE is negative and the FCFF is positive. This is also useful when a firm is highly levered and only a small portion of its value represents equity.

Q2. A firm that is currently experiencing negative free cash flow to equity (FCFE), is highly levered, and pays no dividends is a good candidate for which of the following valuation methods?

A)   Free cash flow to the firm (FCFF).

B)   Earnings Before Interest and Taxes (EBIT) discount.

C)   Dividend discount.

Correct answer is A)

FCFF is superior to FCFE when a firm has negative FCFE and is highly levered.

Q3. An analyst choosing between the free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) valuation approaches recognizes that an increase in leverage:

A)   increases FCFE by the amount of after-tax interest.

B)   does not change FCFF.

C)   reduces FCFE by the amount of the debt.

Correct answer is B)

FCFF = EBIT(1 ? Tax rate) + DEP ? FCInv ? WCInv
FCFE = FCFF ? Int(1 ? Tax rate) + Net borrowing
FCFF is not changed by leverage. However, FCFE is increased by the amount of the debt and is decreased by the amount of after-tax interest.

Q4. Free cash flow to the firm (FCFF) is superior to free cash flow to equity (FCFE) in valuation for firms that are:

A)   highly levered with negative free cash flow to equity.

B)   not paying dividends.

C)   unlevered.

Correct answer is A)       

FCFF is superior to FCFE when a firm has negative FCFE and is highly levered.

Q5. FCFF models are more useful than FCFE models in valuing all of the following EXCEPT:

A)   firms that are making substantial changes to their capital structure.

B)   firms that undergo a leveraged buyout.

C)   firms that have retired all of their debt.

Correct answer is C)

The FCFF models will not be useful in valuing firms that have retired all their debt and have 100% equity in their capital structure. In such a case, the two models would calculate identical values, assuming the firm doesnot have any preferred equity outstanding.

Q6. FCFF models are more suitable than FCFE models for valuing firms that are in the process of changing their capital structure for all of the following reasons EXCEPT:

A)   these firms will have negative FCFE.

B)   value of equity is small compared to the total value of the firm and is sensitive to the assumptions of growth and risk.

C)   operating earnings will not be affected by the change in capital structure.

Correct answer is A)

It is not known whether the firm will have negative FCFE. However, it is true that the relatively small equity value becomes extremely sensitive to assumptions about growth and risk. The operating earnings (EBIT) will not be affected by the change in the capital structure, so FCFF will remain the same as it was prior to the change in capital structure.

Q7. Which types of firms are best valued using the free cashflow to the firm (FCFF) approach?

A)   Firms with significant financial leverage.

B)   Firms that are making no significant change to their capital structure.

C)   Firms that do not pay dividends.

Correct answer is A)

Two types of firms are best valued using the FCFF approach:

1. Firms with lots of debt (i.e., significant leverage).

2. Firms that are in the process of changing their capital structure. Firms that undergo a leveraged buyout are good candidates for valuation using the FCFF approach.

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