HuskyGrad2010

The repayment of a significant amount of outstanding debt will cause free cash flow to equity (FCFE) to:

A) decrease.

B) increase.

C) remain the same.

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Debt repayment will decrease net borrowing and, hence, decrease FCFE because: FCFE = FCFF – [interest expense] (1 – tax rate) + net borrowing.

HuskyGrad2010

An increase in financial leverage will cause free cash flow to equity (FCFE) to:

A) increase in the year the borrowing occurred.

B) decrease in the year the borrowing occurred.

C) decrease or increase, depending on its circumstances.

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An increase in financial leverage will increase net borrowing and, hence, increase FCFE in the year the borrowing occurred because: FCFE = FCFF – [interest expense] (1 – tax rate) + net borrowing

HuskyGrad2010

The repurchase of 20% of a firm’s outstanding common shares will cause free cash flow to the firm (FCFF) to:

A) remain the same.

B) increase.

C) decrease.

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Share repurchases are a use of free cash flows, not a source. FCFF is cash flow that is available to all capital suppliers. Notice the conspicuous absence of repurchases in the following: FCFF = CFO + Int (1 – tax rate) – FCInv.

HuskyGrad2010

Which of the following statements is least accurate? A firm’s free cash flows to equity (FCFE) is the cash available to stockholders after funding:

A) capital expenditure requirements.

B) debt principal repayments.

C) dividend payments.

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A firm’s FCFE is the cash available to stockholders after funding capital expenditures and debt principal repayments.

HuskyGrad2010

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 Expenditures	6.00	6.90	7.94	9.13
Depreciation	4.00	4.60	5.29	6.08
Change in Working Capital	2.00	2.10	2.20	2.40	2.40
FCFF		5.95	7.06	8.25	11.56

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.

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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.

HuskyGrad2010

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 Expenditures	6.00	6.90	7.94	9.13
Depreciation	4.00	4.60	5.29	6.08
Change in Working Capital	2.00	2.10	2.20	2.40	2.40
FCFF		5.95	7.06	8.25	11.56

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.

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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.

HuskyGrad2010

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.

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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.

HuskyGrad2010

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.

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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.

HuskyGrad2010

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.

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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.

HuskyGrad2010

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.

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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.