anshultongia

Using the stable growth free cash flow to the firm (FCFF) model, what is the value of Quality Builders under the assumptions contained in the table below?

Quality Builders Free Cash Flow to the Firm Year 0
EBIT	$500
Depreciation	$200
Capital Spending	$300
Working Capital Additions	$30
Tax Rate	40%
Assumed Constant Growth Rate in Free Cash Flow	5%
Weighted-average Cost of Capital	11%

A) $6,475.00.

B) $2,975.00.

C) $2,833.33.

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The stable growth FCFF model assumes that FCFF grows at a constant rate forever. FCFF in Year 0 is equal to EBIT(1 − tax rate) + Depreciation − Capital Spending − Working Capital Additions = 500(1 − 0.4) + 200 − 300 − 30 = 170. The Firm Value = FCFF1 / (r − gn) = 170(1.05) / (0.11 − 0.05) = $2,975.

anshultongia

SOX, Inc., expects high growth in the next 4 years before slowing to a stable future growth of 3%. The firm is assumed to pay no dividends in the near future and has the following forecasted free cash flow to equity (FCFE) information on a per share basis in the high-growth period:

	Year 1	Year 2	Year 3	Year 4
FCFE	$3.05	$4.10	$5.24	$6.71

High-growth period assumptions:

• 
  SOX, Inc.'s, target debt ratio is 40% and a beta of 1.3.
• 
  The long-term Treasury Bond Rate is 4.0%, and the expected equity risk premium is 6%.

Stable-growth period assumptions:

• 
  SOX, Inc.'s, target debt ratio is 40% and a beta of 1.0.
• 
  The long-term Treasury Bond Rate is 4.0% and the expected equity risk premium is 6%.
• 
  Capital expenditures are assumed to equal depreciation.
• 
  In year 5, earnings are $8.10 per share while the change in working capital is $2.00 per share.
• 
  Earnings and working capital are expected to grow by 3% a year in the future.

What is the present value on a per share basis for SOX, Inc.?

A) $64.24.

B) $77.15.

C) $70.49.

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The required rate of return in the high-growth period is (r) = 0.04 + 1.3(0.06) = 0.118.
The required rate of return in the stable-growth period is (r) = 0.04 + 1.0(0.06) = 0.10.
The Present Value (PV) of the FCFE in the high-growth period is (3.05 / 1.118) + (4.10 / 1.1182) + (5.24 / 1.1183) + (6.71 / 1.1184) = 14.06.
The Terminal Price = Expected FCFEn + 1 / (r − gn) with FCFEn + 1 = FCFE in year 5 = Earnings per share − (Capital Expenditures − Depreciation)(1 − Debt Ratio) − (Change in working capital)(1 − Debt Ratio) = 8.10 − 0(1 − 0.4) − 2.00(1 − 0.4) = 6.90.
The Terminal Price = 6.90 / (0.10 − 0.03) = 98.57.
The PV of the Terminal Price = (98.57 / 1.1184) = 63.09.
The value of a share today is the PV of the FCFE in the high-growth period plus the PV of the Terminal Price = 14.06 + 63.09 = 77.15.

anshultongia

The value of stock under the two-stage FCFE model will be equal to:

A) present value (PV) of FCFE during the extraordinary growth period plus the terminal value.

B) present value (PV) of FCFE during the extraordinary growth and transitional periods plus the PV of terminal value.

C) present value (PV) of FCFE during the extraordinary growth period plus the PV of terminal value.

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The value of stock under the two-stage FCFE model will be equal to the present value of FCFE during the extraordinary growth period plus the present value of the terminal value at the end of this period.

anshultongia

The following information was collected from the financial statements of Bankers Industrial Corp. for the year ended December 31, 2000.

• Earnings before interest and taxes (EBIT) = $6 million.

• Capital expenditures = $1.25 million.

• Depreciation expense = $0.63 million.

• Working capital additions = $0.59 million.

• Cost of debt = 10.5%.

• Cost of equity = 16%.

• Growth rate = 7%.

Bankers is currently operating at their target debt ratio of 40%. The firm’s tax rate is 40%.

The free cash flow to the firm (FCFF) for the current year is:

A) $2.39 million.

B) $3.57 million.

C) $2.31 million.

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The FCFF for the current year is $2.39m = [$6.0m(1 − 0.40)] + $0.63m − $1.25m − $0.59m.

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The appropriate discount rate used in valuing Bankers using FCFF will be:

A) 12.12%.

B) 16.00%.

C) 6.30%.

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The appropriate discount rate to be used is the weighted average cost of capital (WACC), and this is 12.12% = (0.60 × 0.16) + [0.40 × 0.105 × (1 − 0.40)].

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The estimated value of the firm is:

A) $37.61 million.

B) $49.95 million.

C) $46.68 million.

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The value of Bankers using stable-growth FCFF model is $49.95 million, calculated as:
FCFF = $2.39m = [$6.0m(1 − 0.40)] + $0.63m − $1.25m − $0.59m.
WACC = 12.12% = (0.60 × 0.16) + [0.40 × 0.105 × (1 × 0.40)].
Estimated value = $49.95 million = ($2.39m × 1.07) / (0.1212 − 0.07)

anshultongia

In using FCFE models, the assumption of growth should be:

A) independent from the assumptions of other variables.

B) consistent with assumptions of other variables.

C) only consistent with the assumptions of capital spending and depreciation.

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The assumption of growth should be consistent with assumptions about other variables. Net capital expenditures (capital expenditures minus depreciation) and beta (risk) used to calculate required rate of return should be consistent with assumed growth rate.

HuskyGrad2010

Which of the following types of companies is the two-stage free cash flow to equity (FCFE) model best suited for? Companies:

A) growing at a rate similar to or less than the nominal growth rate of the economy.

B) in high growth industries that will face increasing competitive pressures over time, leading to a gradual decline in growth to a stable level.

C) with patents or firms in an industry with significant barriers to entry.

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The two-stage model is best suited to analyzing firms in a high growth phase that will maintain that growth for a specific period, such as firms with patents or firms in an industry with significant barriers to entry. Companies growing at a rate similar to or less than the nominal growth rate of the economy are best suited for the single-stage FCFE Model. Companies in high growth industries correspond to the three-Stage FCFE Model.

HuskyGrad2010

A three-stage free cash flow to the firm (FCFF) is typically appropriate when:

A) growth is currently high and will move through a transitional stage to a steady-state growth rate.

B) the required rate of return is less than the growth rate in the last stage.

C) growth is currently low and will move through a transitional stage to a final stage wherein growth exceeds the required rate of return.

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The three-stage model using either FCFE or FCFF typically assumes that growth is currently high and will move through a transitional stage to a steady-state growth rate. Multi-stage models assume that the required rate of return exceeds the growth rate in the last stage.

HuskyGrad2010

Which of the following statements about the three-stage FCFE model is most accurate?

A) There is a transition period where the growth rate is stable.

B) There is a final phase when growth rate starts to decline.

C) There is a transition period where the growth rate declines.

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In the three-stage FCFE model, there is an initial phase of high growth, a transition period where the growth rate declines, and a steady-state period where growth is stable.

HuskyGrad2010

Which of the following types of company is the E-Model, a three-stage free cash flow to equity (FCFE) Model, best suited for? Companies:

A) with patents or firms in an industry with significant barriers to entry.

B) growing at a rate similar to or less than the nominal growth rate of the economy.

C) in high growth industries that will face increasing competitive pressures over time, leading to a gradual decline in growth to a stable level.

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The three-stage FCFE model, or E-Model, is most suited to analyzing firms currently experiencing high growth that will face increasing competitive pressures over time, leading to a gradual decline in growth to a stable level. The two-stage model is best suited to analyzing firms in a high growth phase that will maintain that growth for a specific period, such as firms with patents or firms in an industry with significant barriers to entry. Companies growing at a rate similar to or less than the nominal growth rate of the economy are best suited for the Stable Growth FCFE Model. A firm that pays out all of its earnings as dividends will have a growth rate of zero (remember g = RR × ROE) and would not be valued using the three-stage FCFE model.

HuskyGrad2010

The one-stage (stable growth) free cash flow models assume:

A) the required rate of return exceeds the growth rate.

B) the required rate of return is less than the growth rate.

C) a constant growth rate for n years and a high growth rate forever thereafter.

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The one-stage model using either free cash flow to equity (FCFE) or free cash flow to the firm (FCFF) assumes that the required rate of return exceeds the growth rate. If this was not the case, the model would produce an unrealistic negative price.