Reading 41: Free Cash Flow Valuation-LOS a习题精选 center, border, available, div

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Session 12: Equity Investments: Valuation Models
Reading 41: Free Cash Flow Valuation

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

 

 

 

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

A) bondholders and preferred stockholders.

B) bondholders.

C) all of the firm's investors.

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FCFF is the cash available to all of the firm’s investors including stockholders, bondholders, and preferred stockholders.

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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)

	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

Additional information for 2006

Fixed capital investment	62.3
Working capital investment	10.5
Net borrowing	13.7

Konteco’s FCFE per share in 2006 is closest to:

A) ￡1.04.

B) ￡2.89.

C) ?￡1.90.

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FCFE is the cash available to common shareholders after funding capital requirements, working capital needs, and debt financing requirements.

Konteco’s 2006 FCFE per share is calculated as (all numbers are in millions of ￡):

Net income	=	48.2
+ depreciation	=	39.8
– capital expenditures	=	62.3
– investment in working capital	=	10.5
+ net borrowing	=	13.7
FCFE	=	28.9
÷ number of common shares	=	10
FCFE2006 per share	=	￡2.89

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The current share value of Konteco’s common stock using the FCFE approach is closest to:

A) ￡37.61.

B) ￡42.83.

C) ￡26.17.

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This is a two-stage FCFE growth model application. To determine the current per-share value using the two-stage FCFE approach, it is necessary to compute (1) the present value of the FCFE for each of the high-growth years (2007, 2008, and 2009) and (2) the present value of the terminal value of the FCFE at the end of high-growth period (year 2010).

Since all components of FCFE are expected to grow at the same rate, FCFE can be projected directly using the common growth rates. (Note: watch out for this simplifying assumption on the exam.)

The two-stage FCFE model can now be applied to determine the value of Konteco’s common stock as follows. First estimate the terminal value using a single-stage FCFE model:

Then calculate the present value of the estimated cash flows, including terminal value, at 15%:

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Free cash flow to the firm (FCFF) models represent the value of the firm’s future cash flow that is:

A) ultimately available to the shareholders.

B) not distributed to shareholders in the form of dividends.

C) not required for capital expenditures to maintain the operation of the firm.

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FCFF models estimate the value of the firm based on the cash flow generated by the firm’s operations that is not required to be reinvested to maintain the operations of the firm.

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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.

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Free cash flow is harder to use than dividends because cash flows from operations must be integrated with those from financing and investing. Free cash flows are after tax. Depreciation is considered because it overstates expenses on a cash basis.

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

A) H-model.

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

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

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The FCFF models, unlike the FCFE or DDM models, value the whole firm rather than just the equity.

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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) Common dividends.

B) Principal repayments.

C) After-tax interest expense.

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FCFF can be calculated by adding cash flows to all claim holders (investors). FCFF = FCFE + [Interest Expense × (1 ? tax rate)] + Principal Repayments ? New Debt Issues + Preferred Dividends.

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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.

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The WACC is the appropriate discount rate to employ when using the FCFF models. To estimate the value of equity when using a FCFF model, an analyst should subtract the market value of the debt from the estimated value of the firm.

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

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

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The value of equity from both approaches will be the same when the assumptions of growth rate are consistent in both approaches (this does not mean that same growth rate is used for both approaches, but the growth rate in earnings should reflect effect of leverage) and bonds (debt outstanding) are correctly priced.

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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.

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Free cash flow to the firm is the cash available to all of the firm’s investors, including stockholders, bondholders, and preferred stockholders. It is cash flow from operations plus after-tax interest expense minus capital expenditures.

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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 less inflows/outflows from debtholders.

C) cash flow from operations less capital expenditures.

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Free cash flow to equity is the cash available to stockholders after funding capital requirements, working capital needs, and debt financing requirements. It is cash flow from operations less capital expenditures less payments to (and plus inflows from) debtholders.