RobertA

Free cash flow to the firm is equal to cash flow from operations minus fixed capital investment:

A) minus pre-tax interest expense.

B) minus after-tax interest expense.

C) plus after-tax interest expense.

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Free cash flow to the firm is equal to cash flow from operations minus fixed capital investment plus after-tax interest expense.

RobertA

Which of the following items is NOT subtracted from the net income to calculate free cash flow to equity (FCFE)?

A) Subtractions to notes payable.

B) Additions to cash.

C) Interest payments to bondholders.

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Interest payments to bondholders are included in the income statement and are already subtracted to calculate net income.

RobertA

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) $97.00.

B) $16.50.

C) $17.00.

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FCFE = CFO − FCInv + net borrowing = $49.50 − $40.00 + $7.50 = $17.00

RobertA

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) $540M.

B) $420M.

C) $300M.

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The free cash flow to the firm is:

FCFF = Net income + (Interest expense)(1 − T) − Capital expenditures + Depreciation

RobertA

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) $11.21.

C) $14.10.

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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,
• 
  PV = 7.05 = 9.0 / (1.13)2, or FV = −9.0, I = 13, PMT = 0, N = 2, Compute PV
• 
  Year 3: 10.0 × (1.10)2 + 3.0 − 2.5 − 1.0 − 1.5 = 10.10
• 
  PV = 7.00 = 10.10 / (1.13)3, or FV = −10.10, I = 13, PMT = 0, N = 3, Compute PV

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

RobertA

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) $0.38.

C) $1.88.

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FCFE = net profit – NetFCInv – WCInv + DebtFin = $1.88 – $1.63 – 0.38 + 0.90 = 0.77

RobertA

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) $6.90.

C) $6.10.

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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.

RobertA

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) $2.90.

B) $7.50.

C) $5.90.

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FCFF = EPS + net non-cash charges + after-tax interest − FCInv − WCInv
FCFF= $4.00 + 3.00 +$2.40 − $2.00 −1.50 = $5.90

RobertA

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 Period	Transitional Period	Stable-Growth Period
Duration	2 Years	5 Years
Earnings growth rate	45%	Will decline 8% per year to 5% in the stable-growth period	5%
Growth in Capital Expenditures	30%	Increases by 8% per year	Same as Depreciation
Growth in Depreciation	30%	Increases by 13% per year	Same as Capital Expenditures
Change in Working Capital	Given Below	Given Below	$2.25 per share in Year 8
Shareholder Required Return	25%	15%	10%

	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 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 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) $6.10.

C) $3.35.

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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

RobertA

Harrisburg Tire Company (HTC) forecasts the following for 2007.

• 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 firm's estimated earnings growth rate is:

A) 4.8%.

B) 8.0%.

C) 6.4%.

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Click for Answer and 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

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The forecasted free cash flow to equity is:

A) $300M.

B) $420M.

C) $540M.

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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 − (4 / 10)] × (800M − 500M) = 420M

where:
DR = target debt to asset ratio