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In forecasting free cash flows it is common to assume that:
A)
the firm has no non-cash expenses.
B)
historical and future free cash flow will be the same.
C)
the firm adheres to a target capital structure.




A target debt ratio is usually assumed to remain constant. Historical cash flows are often projected forward with a growth rate.

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In forecasting free cash flows it is common to assume that investment in working capital:
A)
will be financed using the target debt ratio.
B)
is greater than fixed capital investment during a growth phase.
C)
will equal fixed capital investment.



It is usually assumed that the investment in working capital will be financed consistent with the target debt ratio.

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The following table provides background information on a per share basis for TOY Inc. in the year 0:
Current Information:Year 0
Earnings$5.00
Capital Expenditures$2.40
Depreciation$1.80
Change in Working Capital$1.70

TOY Inc.'s target debt ratio is 30% and has a required rate of return of 12%. Earnings, capital expenditures, depreciation, and working capital are all expected to grow by 5% a year in the future. Assume that capital expenditures and working capital are financed at the target debt ratio.
In year 0, what is the free cashflow to equity (FCFE) for TOY Inc.?
A)
$4.31.
B)
$3.39.
C)
$2.70.



Year 0 FCFE = Earnings per share − (Capital Expenditures − Depreciation)(1 − Debt Ratio) − Change in working capital (1 − Debt Ratio) = 5.00 − (2.40 − 1.80)(1 − 0.3) − (1.7)(1 − 0.3) = 3.39

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A common approach to forecasting free cash flows is to:
A)
project net income and expected capital expenditures.
B)
calculate historical free cash flow and apply an expected growth rate.
C)
project earnings before interest and taxes (EBIT) and expected capital expenditures.



Historical free cash flows are often used for forecasting.

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The difference between the value estimate produced by the dividend discount model (DDM) and the one produced by the free cash flow to equity (FCFE) model can be accounted for by which of the following?
A)
The value in controlling the firm's dividend policy.
B)
Different sales forecast.
C)
Different estimates of model risk.



The difference between the value estimate produced by the DDM and the one produced by the FCFE model can be interpreted as the value of controlling the firm's dividend policy.

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The difference between the value estimate produced by the dividend discount model (DDM) and the one produced by the free cash flow to equity (FCFE) model can be accounted for by which of the following?
A)
The value in controlling the firm's dividend policy.
B)
Different sales forecast.
C)
Different estimates of model risk.



The difference between the value estimate produced by the DDM and the one produced by the FCFE model can be interpreted as the value of controlling the firm's dividend policy.

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The primary difference between the three-stage DDM and the FCFE model is:
A)
growth rate assumptions.
B)
the definition of cash flows.
C)
cost of equity.




The primary difference between the dividend discount models and the free cash flow from equity models lies in the definition of cash flows. The FCFE model uses residual cash flows after meeting all financial obligations and investment needs. The DDM uses a strict definition of cash flows to equity, that is, the expected dividends on the stock.

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Currently, a firm has no outstanding debt. If the firm would add a small amount of leverage to its balance sheet, what should be the impact on the firm's value? There would be:
A)
a decrease in value due to higher interest expense.
B)
an increase in value due to interest tax shields.
C)
no change in firm value.



The amount of financial leverage used by a firm will affect its value. For small amounts of leverage, the additional bankruptcy risk will be low, and will be more than offset by the additional value of interest tax shields.

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Currently, a firm has no outstanding debt. If the firm would add a small amount of leverage to its balance sheet, what should be the impact on the firm's value? There would be:
A)
a decrease in value due to higher interest expense.
B)
an increase in value due to interest tax shields.
C)
no change in firm value.



The amount of financial leverage used by a firm will affect its value. For small amounts of leverage, the additional bankruptcy risk will be low, and will be more than offset by the additional value of interest tax shields.

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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 Expenditures6.006.907.949.13
Depreciation4.004.605.296.08
Change in Working Capital2.002.102.202.402.40
FCFF5.957.068.2511.56


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.



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.

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