Q27. What is the expected growth rate in FCFF that Carson must have used to generate his valuation of $1.08 billion?

A)   7%.

B)   12%.

C)   5%.

Q28. If Carson had estimated FCFE under the assumption that Overhaul Trucking maintains a target debt-to-asset ratio of 36 percent for new investments in fixed and working capital, what would be his forecast of 2006 FCFE?

A)   $9.6 million.

B)   $26.5 million.

C)   $16.9 million.

Q29. Regarding the statements made by Carson and Eckhardt about the value of Overhaul in the high-growth scenario:

A)   only one is correct.

B)   both are correct.

C)   both are incorrect.

Q30. Industrial Light currently has:

• Expected free cash flow to the firm in one year = $4.0 million.
• Cost of equity = 12%.
• Weighted average cost of capital = 10%.
• Total debt = $30.0 million.
• Long-term expected growth rate = 5%. 

What is the value of equity?

A)   $50,000,000.

B)   $80,000,000.

C)   $44,440,000.

Q31. A firm has projected free cash flow to equity next year of $1.25 per share, $1.55 in two years, and a terminal value of $90.00 two years from now, as well. Given the firm’s cost of equity of 12%, a weighted average cost of capital of 14%, and total outstanding debt of $30.00 per share, what is the current value of equity?

A)   $74.10.

B)   $41.54.

C)   $71.74.

Q27. What is the expected growth rate in FCFF that Carson must have used to generate his valuation of $1.08 billion? fficeffice" />

A)   7%.

B)   12%.

C)   5%.

Correct answer is A)

Since Firm Value = FCFF₁ / (WACC ? g), we first need to determine FCFF₁, which is FCFF in 2006: FCFF = NI + NCC + [Int × (1 - tax rate)] – FCInv – WCInv
= 16.9 + 80 + [34 × (1 - .35)] – [(480-240) - (400-160) + 80] – [(55 - 70) - (50 - 50)]
= 16.9 + 80 + 22.1 – 80 – (-15) = 54 

Firm Value = FCFF₁ / (WACC - g) 

1080 = 54 / (0.12 ? x)

[(1080)(0.12)] – 1080x = 54
129.6 – 1080x = 54
75.6 = 1080x
0.07 = x
The expected growth rate in FCFF that ffice:smarttags" />Carson must have used is 7%. (Study Session 12, LOS 42.k)

Q28. If Carson had estimated FCFE under the assumption that Overhaul Trucking maintains a target debt-to-asset ratio of 36 percent for new investments in fixed and working capital, what would be his forecast of 2006 FCFE?

A)   $9.6 million.

B)   $26.5 million.

C)   $16.9 million.

Correct answer is B)

FCFE = NI – [(1 - DR) × (FCInv - Dep)] – [(1 - DR) × WCInv]

Where: DR = target debt to asset ratio

FCFE = 16.9 – [(1 – 0.36) × [((480-240) - (400-160) + 80) – 80)] – [(1 – 0.36) × ((55 – 70) – (50 – 50))]
= 16.9 – (.64 × 0) – (0.64 × (-15))
= 16.9 + 0 + 9.6 = 26.5

(Study Session 12, LOS 42.k)

Q29. Regarding the statements made by Carson and Eckhardt about the value of Overhaul in the high-growth scenario:

A)   only one is correct.

B)   both are correct.

C)   both are incorrect.

Correct answer is B)

This is a complex problem. It would help to create a table:

	2006 (year 1)	2007 (year 2)	2008 (year 3)	2009 (year 4)	2010 (year 5)	2011 (year 6)	2012 (year 7)
Growth in FCFE (given)	n/a	30%	30%	30%	21%	12%	3%
Forecast FCFE (calculated)	5.0	6.50	8.45	10.99	13.29	14.89	15.33
Required return to equity (given)	20%	20%	20%	20%	15%	15%	15%
Total discount factor (calculated)	1.20	(1.20)2	(1.20)3	(1.20)4	(1.20)4(1.15)	(1.20)4(1.15)2	(1.20)4(1.15)3
PV of FCFE	4.17	4.51	4.89	5.30	5.57	5.43	4.86

We begin with the forecast growth rates in FCFE in line 1. Since we have previously calculated that FCFE is $5 million in 2006, we can use the growth rates from line 1 to forecast FCFE in each year on line 2.

Line 3, required return to equity, is given. Using that, we can calculate discount factors in line 4.

Notice that the total discount factor is simply each year’s factor multiplied together. For example, the total discount factor for year 4 is (1.20)⁴ so the total discount factor for year 5, when the year 5 required rate of return drops from 20% to 15%, becomes (1.20)⁴(1.15).

Using the total discount factors from line 4, we can calculate the present value of each year’s cash flow in line 5. For example, the present value of year 2010 FCFE of $13.29 million will be $13.29 / [(1.20)⁴(1.15)] or $5.57 million.

Once we have the discounted cash flows for each year, we need to calculate the terminal value. Terminal value will be:

TV = (15.33)(1.03) / (0.10 - 0.03)

TV = 15.7899 / 0.07

TV = $225.57 million

Note that the required rate of return used for the terminal value is the rate for the steady-growth period, which is lower than that used in the high-growth phase (stage) or the declining growth phase (stage two).

We now need to discount terminal value back using the total discount factor for 2012:

PV of terminal value = $225.57 million / [(1.20)⁴(1.15)³]

PV of terminal value = $71.53 million

Adding together the discounted cash flows for each year with the discounted terminal value, we have:

Equity value = 4.17 + 4.51 + 4.89 + 5.30 + 5.57 + 5.43 + 4.86 + 71.53 = $106.26 million

Since the equity value of the firm is $106.26 million, Burcar should be willing to pay up to $106.26 × 0.15 = $15.94 million for a 15% stake in the firm. Since this is slightly less than $16 million, Carson’s statement is correct. The terminal value represents ($71.53 / $106.26) = 67.3% of the firm’s present value, so Eckhardt’s statement is also correct. (Study Session 12, LOS 42.k)

Q30. Industrial Light currently has:

• Expected free cash flow to the firm in one year = $4.0 million.
• Cost of equity = 12%.
• Weighted average cost of capital = 10%.
• Total debt = $30.0 million.
• Long-term expected growth rate = 5%. 

What is the value of equity?

A)   $50,000,000.

B)   $80,000,000.

C)   $44,440,000.

Correct answer is A)

The overall value of the firm is $4,000,000 / (0.10 – 0.05) = $80,000,000. Thus, the value of equity is $80,000,000 – $30,000,000 = $50,000,000.

Q31. A firm has projected free cash flow to equity next year of $1.25 per share, $1.55 in two years, and a terminal value of $90.00 two years from now, as well. Given the firm’s cost of equity of 12%, a weighted average cost of capital of 14%, and total outstanding debt of $30.00 per share, what is the current value of equity?

A)   $74.10.

B)   $41.54.

C)   $71.74.

Correct answer is A)

Value of equity = $1.25 / (1.12)¹ + $1.55 / (1.12)² + $90.00 / (1.12)² = $74.10