Equity Valuation【Reading 40】Sample 2012

RobertA

Free cash flow to the firm valuation uses which discount rate?

A) After-tax cost of debt.

B) Cost of equity.

C) Weighted average cost of capital.

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Free cash flow to the firm valuation uses the opportunity cost relevant to the overall firm, which is the weighted average cost of capital.

anshultongia

Terminal value in a multi-stage free cash flow to equity (FCFE) valuation model is often calculated as the present value of:

A) a two-stage valuation model's price.

B) free cash flow divided by the growth rate.

C) FCFE divided by the total of required rate on equity minus growth.

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Terminal values are usually calculated as the present value of the price produced by a constant-growth model as of the beginning of the last stage, which is FCFE / (required rate on equity – growth).

anshultongia

Terminal value in multi-stage free cash flow valuation models is often calculated as the present value of:

A) a two-stage valuation model's price.

B) free cash flow divided by the growth rate.

C) a constant growth model's price as of the beginning of the last stage.

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Terminal values are usually calculated as the present value of the price produced by a constant-growth model as of the beginning of the last stage.

anshultongia

In the two-stage FCFE model, the required rate of return for calculating terminal value should be:

A) higher than the required rate of return used for the high-growth phase.

B) lower than the required rate of return used for the high-growth phase.

C) equal to the average required rate of return for the industry.

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In most cases, the required rate of return used to calculate the terminal value should be lower than the required rate of return used for initial high-growth phase. During the stable period the firm is less risky and the required rate of return is therefore lower.

anshultongia

In five years, a firm is expected to be operating in a stage of its life cycle wherein its expected growth rate is 5%, indefinitely; its required rate of return on equity is 11%; its weighted average cost of capital is 9%; and the free cash flow to equity in year 6 will be $5.25 per share. What is its projected terminal value at the end of year 5?

A) $51.93.

B) $131.25.

C) $87.50.

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Terminal value = FCFE / (k − g) = $5.25 / (0.11 − 0.05) = $87.50

anshultongia

A firm has:

• Free cash flow to equity = $4.0 million.
• Cost of equity = 12%.
• Long-term expected growth rate = 5%.
• Value of equity per share = $57.14 per share.
  

What will happen to the value of the firm if free cash flow to equity decreases to $3.2 million?

A) There is insufficient information to tell.

B) The value will increase.

C) The value will decrease.

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Everything else being constant, a decrease in free cash flow to equity should decrease the value of the firm.

anshultongia

A firm has:

• Free cash flow to the firm = $4.0 million.
• Weighted average cost of capital = 10%.
• Total debt = $30.0 million.
• Long-term expected growth rate = 5%.
• Value of the firm = $50.00 per share.
  

What will happen to the value of the firm if the weighted average cost of capital increases to 12%?

A) The value will remain the same.

B) The value will increase.

C) The value will decrease.

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Everything else being constant, an increase in the relevant required rate of return should decrease the value of the firm.

anshultongia

A firm has:

• Free cash flow to equity = $4.0 million.
• Cost of equity = 12%.
• Long-term expected growth rate = 5%.
• Value of equity per share = $57.14 per share.
  

What will happen to the value of equity if the cost of equity decreases to 10%?

A) There is insufficient information to tell.

B) The value will increase.

C) The value will decrease.

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Everything else being constant, a decrease in the relevant required rate of return should increase the value of the equity per share.

anshultongia

Industrial Light currently has:

• Free cash flow to equity = $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) $60,000,000.

B) $57,142,857.

C) $27,142,857.

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The value of equity is [($4,000,000)(1.05) / (0.12 – 0.05)] = $60,000,000.

anshultongia

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.In year 1, what is the forecasted free cash flow to equity (FCFE) for TOY, Inc.?

A) $3.56.

B) $4.53.

C) $4.31.

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Earnings = 5 × 1.05 = 5.25, capital expenditures = 2.4 × 1.05 = 2.52, deprecation = 1.8 × 1.05 = 1.89, change in working capital = 1.7 × 1.05 = 1.785, FCFE = Earnings per share − (Capital Expenditures − Depreciation)(1 − Debt Ratio) − (Change in working capital)(1 − Debt Ratio) = 5.25 − (2.52 − 1.89)(1 − 0.3) − (1.785)(1 − 0.3) = 3.56.

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What is the value of TOY, Inc.'s, stock given the above assumptions?

A) $61.57.

B) $64.71.

C) $50.86.

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The value of the stock = FCFE1 / (r − gn) = 3.56 / (0.12 − 0.05) = 50.86.