Reading 42: Free Cash Flow Valuation- LOS a～ Q1-11

equity, interpret, available

LOS a: Define and interpret free cash flow to the firm (FCFF) and free cash flow to equity (FCFE).

Q1. Free cash flow to the firm (FCFF) is the cash available to:

A) all of the firm's investors.

B) bondholders and preferred stockholders.

C) bondholders.

Q2. Which one of the following is least likely to be added to free cash flow to equity (FCFE) to calculate the free cash flow to the firm (FCFF)?

A) Principal repayments.

B) After-tax interest expense.

C) Common dividends.

Q3. An analyst will get the best estimate of the value of a firm’s equity using FCFF models, when value of equity is calculated by subtracting the:

A) market value of debt outstanding from the value of the whole firm.

B) book value of debt outstanding from the value of the whole firm.

C) market value of debt outstanding from the value of the whole firm and cost of equity is used as the discount rate in the FCFF model.

Q4. Which of the following is a condition for the value of equity obtained from free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) approaches to be same?

A) Growth rate used in both approaches should be equal.

B) Assumptions of the growth rate should be consistent in both approaches.

C) Market value of bonds should be lower than the book value.

Q5. Which of the following statements about the definition of free cash flow to the firm is TRUE? It is:

A) CFO ? FCInv ? inflows/outflows from debtholders.

B) cash available to stockholders.

C) CFO + [Int × (1 ? tax rate)] ? FCInv.

Q6. Which of the following statements about the definition of free cash flow to equity is TRUE? It is:

A) cash available to all capital suppliers.

B) cash flow from operations less capital expenditures.

C) cash flow from operations less capital expenditures less inflows/outflows from debtholders.

Q7. Which of the following statements about the use of free cash flows in valuation is TRUE?

A) It is more challenging to use than dividends.

B) Free cash flow to the firm is calculated before taxes.

C) Depreciation is ignored because it is not a cash flow.

Q8. Which of the following models least accurately value a firm’s equity?

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

B) H-model.

C) Three-stage dividend discount model (DDM) model.

Q9. Marc Gnocci, CFA, is considering the inclusion of the common stock of Konteco Incorporated in several of his clients’ accounts. Konteco provides centralized telephone systems in remote areas of underdeveloped nations. As a result of a recent economic downturn, the price of Konteco’s stock price has declined dramatically. However, given the current economic outlook and Konteco’s long-range earnings forecast, Gnocci believes that Konteco is currently trading below its intrinsic value and has a required return of 15%. In order to determine if Konteco is indeed underpriced, and to prepare a recommendation for his clients, Gnocci has assembled the information presented in the following tables. Gnocci has decided to estimate the current value of Konteco’s stock using the free cash flow to equity (FCFE) approach. He believes that Konteco’s FCFE will grow at 20% for three years after 2006, then stabilize at 3% from 2010 onward. Gnocci assumes that Konteco’s capital expenditures, depreciation, and working capital will change in direct proportion to FCFE.

Konteco Incorporated

Income Statements for Year Ending December 31, 2006

(￡ Millions)

< > td>	2006	2005
Net sales	530	500
Costs (excluding depreciation)	381.6	360.0
Depreciation	39.8	37.5
Total operating costs	421.4	397.5
Earnings before interest and tax	108.6	102.5
Interest expense	(16.0)	(13.9)
Earnings before taxes	92.6	88.6
Taxes (40%)	(37.0)	(35.4)
Net income before preferred dividends	55.6	53.2
Preferred dividends	(7.4)	(6.0)
Net income available for common dividends	48.2	47.2
Common dividends	29.7	40.8
Additions to retained earnings	18.5	6.4
Number of shares	10	10
Dividends per share	2.97	4.08