RobertA

A control perspective is most consistent with which of the following valuation approaches?

A) Free cash flow (FCF).

B) Dividends.

C) Price to enterprise value.

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Dividend policy can be changed by the buyer of a firm. Thus, the FCF perspective looks to the source of dividends in a position of control rather than directly at dividends. The price to enterprise value approach does not focus on cash flows.

RobertA

An analyst is performing an equity valuation for a minority equity position in a dividend paying multinational. The appropriate model for this analysis is most likely:

A) FCFE approach.

B) The Dividend Discount approach.

C) FCFF approach.

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The dividend discount model is most appropriate for valuing a minority equity position in a dividend-paying company. The free cash flow approach looks to the source of dividends from the perspective of an owner that has control rather than directly at dividends.

RobertA

Michael Ballmer is an equity analyst with New Horizon Research. The firm has historically relied on dividend and residual income valuation models to value equity, but the firm’s director of research, Doug Leads, has decided that the firm needs to incorporate free cash flow valuations into its practices. Therefore, Leads decides to send Ballmer to a seminar on free cash flow valuation.
Upon his return from the convention, Ballmer is excited to share his newfound knowledge with his co-workers. Ballmer is asked to give a debriefing to New Horizon’s team of equity analysts, where he makes the following statements:

Statement 1:	Free cash flow to the firm is the amount of the firm's cash flow that is free for the firm to use in making investments after cash operating expenses have been covered.
Statement 2:	Free cash flow to equity, then, is the amount of the firm’s cash flow that is free for equity holders after covering cash operating expenses, working capital and fixed capital investments, interest principal payments to bondholders, and required divided payments.
Statement 3:	One of the benefits of free cash flow valuation is that the value of the firm and the value of equity can be found by discounting free cash flow to the firm and free cash flow to equity, respectively, by the WACC.

As part of his presentation, Ballmer includes a short example of how to calculate free cash flow to equity. The figures from his example are included below.

Figure 1: Example Balance Sheet
	20X2	20X1
Cash	$632	$245
Accounts receivable	$208	$105
Inventory	$8,249	$8,209
Current assets	$9,089	$8,559
Gross PPE	$22,499	$22,722
Accumulated depreciation	($3,251)	($2,875)
Total assets	$28,337	$28,406
Accounts payable	$4,864	$4,543
Short-term debt	$2,491	$2,996
Current liabilities	$7,355	$7,539
Long-term debt	$4,528	$5,039
Common stock	$729	$735
Retained earnings	$15,725	$15,093
Total liabilities and owner's equity	$28,337	$28,406

Figure 2: Example Cash Flow From Operations
	20X2	20X1
Net income	$1,783	$2,195
Depreciation	$1,733	$1,667
WCInv	($178)	$357
Cash flow from operations	$3,694	$4,219

After discussing the calculation of free cash flow to the firm and free cash flow to equity from historical information, Ballmer proceeds to explain the major approaches for forecasting free cash flow. He focuses his discussion on forecasting the components of free cash flow as this method is more flexible. During his presentation, several of the analysts notice that the formula for forecasting free cash flow to equity does not include net borrowing. They bring this to Ballmer’s attention, and he states that he will look into the formula and send out an updated presentation after the meeting.
A week after the meeting, Jonathan Hodges approached Ballmer regarding two issues he had while applying free cash flow based valuations. The first issue that Hodges had was that he calculated the equity value of a firm using both free cash flow to equity based and dividend-based valuations and arrived at different values. The second issue that Hodges came across was the effect of a change in a firm’s target leverage on FCFE. One of the firms that Hodges was analyzing may reduce leverage, and Hodges needs to know if this will affect his valuation.Regarding statements 1 and 2, are Ballmer’s interpretations of free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) CORRECT?

A) No, neither interpretation is correct.

B) Yes, both interpretations are correct.

C) No, only one interpretation is correct.

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Free cash flow to the firm (FCFF) is the cash flows that are free to investors after cash operating expenses (including taxes but excluding interest expense), working capital investments, and fixed capital investments have been made. Free cash flow to equity (FCFE) is FCFF less interest payments to bondholders and net borrowing from bondholders. (Study Session 12, LOS 40.a)

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Is Ballmer’s third statement regarding the computation of firm value and equity value CORRECT?

A) No, free cash flow to equity should be discounted at the required return on equity.

B) Yes.

C) No, both free cash flow to the firm and free cash flow to equity should be discounted at the required rate of return on equity.

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The value of a firm is the expected future free cash flow to the firm (FCFF) discounted at the firm’s weighted average cost of capital (WACC). The value of the firm’s equity is the expected future free cash flow to equity discounted at the required return on equity. (Study Session 12, LOS 40.d)

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Based on figures 1 and 2, the 20X2 free cash flow to equity (FCFE) for Ballmer’s example firm is:

A) $3,222.

B) $2,901.

C) $3,406.

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Free cash flow to equity (FCFE) can be computed as:

FCFE = CFO − FCInv + net borrowing

Based on the figures included in the example, fixed capital investment (FCInv) is –$223 (= $22,499 − $22,722) and net borrowing is –$1,016 (= $2,491 + $4,528 − $2,996 − $5,039).
FCFE is therefore: FCFE = $3,694 + $223 − $1,016 = $2,901. (Study Session 12, LOS 40.d)

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Which of the following statements regarding forecasting FCFE using the components of free cash flow method and net borrowing is most accurate?

A) The target debt-to-asset ratio accounts for the financing of new investment in fixed capital and working capital.

B) Investment in fixed capital and net borrowing are assumed to offset each other.

C) Net income already accounts for interest expense; therefore, net borrowing is not needed.

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When forecasting FCFE, it is common to assume that a firm will maintain a target debt-to-asset ratio for new investments in fixed capital and working capital. Based on this assumption, the formula for forecasting FCFE is:

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

By multiplying the fixed capital and working capital investments by one minus the target debt-to-asset ratio, you are left with the investment amount less the amount financed by debt, which is the net borrowing amount. Therefore, this formula accounts for net borrowing through the target debt-to-asset ratio. (Study Session 12, LOS 40.e)

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Should dividend-based and free cash flow from equity (FCFE) based valuations result in different equity values for a firm?

A) No, both models should result in the same value.

B) Yes, dividend-based valuations would be higher for firms with large, consistent dividends.

C) Yes, the free cash flow from equity valuation would be higher if there were a premium associated with control of the firm.

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The ownership perspectives of dividend-based and FCFE based valuations are different. Dividend-based valuations take the perspective of minority shareholders, while FCFE based valuations take the perspective of an acquirer who will assume a controlling position in the firm. If investors were willing to pay a premium for a controlling position in the firm, then the equity value computed under the FCFE approach would be higher. (Study Session 12, LOS 40.b)

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Which of the following statements regarding the effect a decrease in leverage has on a firm’s free cash flow from equity (FCFE) is most accurate?

A) FCFE is unaffected by changes in leverage.

B) Current year FCFE increases, but future FCFE will be reduced.

C) Current year FCFE decreases, but future FCFE will be increased.

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Changes in leverage do have a small effect on FCFE. A decrease in leverage will cause the current year FCFE to decrease through the repayment of debt. Future FCFE will be increased because interest expense will be lower. (Study Session 12, LOS 40.g)

RobertA

Free cash flow to equity valuation uses which discount rate?

A) Cost of equity.

B) Weighted average cost of capital.

C) After-tax cost of debt.

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Free cash flow to equity valuation uses the opportunity cost relevant to stockholders, which is the cost of equity.

RobertA

When using the two-stage FCFE model, if increases in working capital appear too high the analyst should:

A) use changes that are based upon a working capital ratio that is closer to the industry average.

B) normalize them to be equal to zero.

C) switch to a three-stage model.

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The best solution is to use changes that are based upon a working capital ratio that approximates the industry average. The problem will not be eliminated by switching to a three-stage FCFE model.

RobertA

When using the two-stage FCFE model, if increases in working capital appear too high the analyst should:

A) use changes that are based upon a working capital ratio that is closer to the industry average.

B) normalize them to be equal to zero.

C) switch to a three-stage model.

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The best solution is to use changes that are based upon a working capital ratio that approximates the industry average. The problem will not be eliminated by switching to a three-stage FCFE model.

RobertA

Free cash flow approaches are the best source of value when:

A) dividends are not paid.

B) a firm has significant minority interest.

C) return on assets is falling.

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Free cash flow approaches are best when dividends are not paid. Both remaining responses have nothing to do with the decision.

RobertA

Free cash flow (FCF) approaches are the best source of value when:

A) a firm has no preferred stock.

B) a firm has significant minority interest.

C) dividends are paid but do not reflect the company's capacity to pay dividends.

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FCF approaches are best when dividends are paid but do not appear to be representative of the firm’s capacity to pay them. Both remaining responses have nothing to do with the decision.

RobertA

Mark Washington, CFA, uses a two-stage free cash flow to equity (FCFE) discount model to value Texas Van Lines. His analysis yields an extremely low value, which he believes is incorrect. Which of the following is least likely to be a cause of this suspect valuation estimate?

A) The cost of equity estimate in the stable growth period is too high for a stable firm.

B) Earnings are temporarily depressed because of a one-time extraordinary accounting charge in the most recent fiscal year.

C) The forecast of working capital as a percentage of revenues in the stable growth period is not large enough to maintain the long-term sustainable growth rate.

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The larger the estimate of working capital as a percentage of revenues, the larger the investment in net working capital, and the lower the FCFE in the stable period. A low stable-period FCFE estimate will result in a low estimate of value today. The solution is to use a working capital ratio closer to the long-run industry average.
If the cost of equity estimate in the stable growth period is too high, the terminal value will be too low. Because the terminal value typically makes up a large portion of the current value, this will cause the current value estimate to be too low. The solution is to use a cost of equity estimate based on a beta of one.
If earnings are temporarily depressed, all the FCFE estimates will be low, and the current value estimate will be low. The solution is to use an estimate of long-run normalized earnings.

RobertA

Free cash flow (FCF) approaches are the best source of value when:

A) FCFs track profitability closely over the analyst's forecast horizon.

B) a firm is paying a dividend that is higher than the industry average.

C) a firm has preferred stock.

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FCF approaches are best when those flows are a good indication of a firm’s profitability over the analyst’s forecast horizon.