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.

HuskyGrad2010

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.

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Historical free cash flows are often used for forecasting.

HuskyGrad2010

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.

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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

HuskyGrad2010

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.

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

HuskyGrad2010

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.

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

RobertA

Harrisburg Tire Company (HTC) forecasts the following for 2007.

• Earnings (net income) = $600M.
• Dividends = $120M.
• Interest expense = $400M.
• Tax rate = 40%.
• Depreciation = $500M.
• Capital spending = $800M.
• Total assets = $10B (book value and market value).
• Debt = $4B (book value and market value).
• Equity = $6B (book value and market value).

The firm's working capital needs are negligible, and they plan to continue to operate at their current capital structure.The firm's estimated earnings growth rate is:

A) 4.8%.

B) 8.0%.

C) 6.4%.

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Click for Answer and Explanation

The firm's estimated earnings growth rate is the product of its retention ratio and ROE:
g = RR × (ROE) = [(600 − 120) / 600] × (600 / 6000) = 0.08

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The forecasted free cash flow to equity is:

A) $300M.

B) $420M.

C) $540M.

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Since working capital needs are negligible, the free cash flow to equity is:
FCFE = Net income − [1 − DR)] × [FCInv − Depreciation] − [(1 − DR) × WCInv]
FCFE = 600M − [1 − (4 / 10)] × (800M − 500M) = 420M

where:
DR = target debt to asset ratio

RobertA

BOX Inc. earned $4.55 per share last year. The firm had capital expenditures of $1.75 per share and depreciation expense of $1.05. BOX Inc. has a target debt ratio of 0.25.

	High-Growth Period	Transitional Period	Stable-Growth Period
Duration	2 Years	5 Years
Earnings growth rate	45%	Will decline 8% per year to 5% in the stable-growth period	5%
Growth in Capital Expenditures	30%	Increases by 8% per year	Same as Depreciation
Growth in Depreciation	30%	Increases by 13% per year	Same as Capital Expenditures
Change in Working Capital	Given Below	Given Below	$2.25 per share in Year 8
Shareholder Required Return	25%	15%	10%

	Yr 0	Yr 1	Yr 2	Yr 3	Yr 4	Yr 5	Yr 6	Yr 7
EPS	4.55	6.60	9.57	13.11	16.91	20.46	23.12	24.27
Capital Expenditures	1.75	2.28	2.96	3.19	3.45	3.73	4.02	4.35
Depreciation	1.05	1.37	1.77	2.01	2.27	2.56	2.89	3.27
Change in WC	0.90	1.10	1.40	1.60	1.80	2.00	2.20	2.10
FCFE			7.63	11.01	14.67	18.08	20.62	21.89

In year 1, what is the free cashflow to equity (FCFE) for BOX Inc.?

A) $5.09.

B) $6.10.

C) $3.35.

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Year 1 FCFE = Earnings per share − (Capital Expenditures – Depreciation)(1 − Debt Ratio) − Change in working capital (1 − Debt Ratio)
Year 1 FCFE = 6.60 − (2.28 − 1.37)(1 − 0.25) – (1.1)(1 − 0.25) = 5.09

RobertA

On a per share basis for a firm:

• Sales are $10.00.
• Earnings per share (EPS) is $4.00.
• Depreciation is $3.00.
• After-tax interest is $2.40.
• Investment in working capital is $1.50.
• Investment in fixed capital is $2.00.
  

What is the firm’s expected free cash flow to the firm (FCFF) per share?

A) $2.90.

B) $7.50.

C) $5.90.

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FCFF = EPS + net non-cash charges + after-tax interest − FCInv − WCInv
FCFF= $4.00 + 3.00 +$2.40 − $2.00 −1.50 = $5.90

RobertA

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.

In year 5, what is the free cash flow to equity (FCFE) for SOX Inc.?

A) $7.30.

B) $6.90.

C) $6.10.

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In year 5, FCFE = 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.

RobertA

A firm currently has sales per share of $10.00, and expects sales to grow by 25% next year. The net profit margin is expected to be 15%. Fixed capital investment net of depreciation is projected to be 65% of the sales increase, and working capital requirements are 15% of the projected sales increase. Debt will finance 45% of the investments in net capital and working capital. The company has an 11% required rate of return on equity. What is the firm’s expected free cash flow to equity (FCFE) per share next year under these assumptions?

A) $0.77.

B) $0.38.

C) $1.88.

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FCFE = net profit – NetFCInv – WCInv + DebtFin = $1.88 – $1.63 – 0.38 + 0.90 = 0.77