HuskyGrad2010

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%.

Scenario 2 FCFF	Year 0 (last year)	Year 1	Year 2	Year 3	Year 4
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

Assuming that Schneider, Inc., slightly increases its financial leverage, what should happen to its firm value? The firm value should:

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

B) increase due to the additional value of interest tax shields.

C) decline due to the increase in risk.

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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.

HuskyGrad2010

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.

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A firm’s FCFE is the cash available to stockholders after funding capital expenditures and debt principal repayments.

HuskyGrad2010

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.

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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.

HuskyGrad2010

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

A) increase in the year the borrowing occurred.

B) decrease in the year the borrowing occurred.

C) decrease or increase, depending on its circumstances.

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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

HuskyGrad2010

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

A) decrease.

B) increase.

C) remain the same.

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Debt repayment will decrease net borrowing and, hence, decrease FCFE because: FCFE = FCFF – [interest expense] (1 – tax rate) + net borrowing.

HuskyGrad2010

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).

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The optimal capital structure is the mix of debt and equity that will maximize the value of the firm and minimize the WACC.

HuskyGrad2010

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

A) increase because the FCFF will increase.

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

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

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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.

HuskyGrad2010

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).

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The FCFFs are normally unaffected by the changes in leverage, as these are the cash flows before the debt payments.

HuskyGrad2010

Dividends paid out to the shareholders:

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

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

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

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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.

HuskyGrad2010

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

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

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

C) FCFE can be negative but dividends cannot.

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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.