Table of Contents
CFA Level 2 – Equity, Session 12-Reading 43
Free Cash Flow Valuation – LOS a
(Practice Questions, Sample Questions)
1. Free cash flow to the firm valuation uses which discount rate?
A) Weighted average cost of capital.
B) After-tax cost of debt.
C) Cost of equity.
Explanation: (A) Free cash flow to the firm valuation uses the opportunity cost relevant to the overall firm, which is the weighted average cost of capital.
2. Valuation with free cash flow to equity and free cash flow to the firm:
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A) use different discount rates.
B) both use the cost of equity.
C) both use the after-tax cost of debt.
Explanation: (A) Free cash flow to the firm uses the weighted average cost of capital and free cash flow to equity uses the cost of equity. The key is to use a discount rate that reflects the opportunity cost of the indicated investor group.
3. If a firm is valued using FCFF, the relevant discount rate is the:
A) before-tax cost of equity.
B) after-tax weighted average cost of capital.
C) before-tax weighted average cost of capital.
Explanation: (B) Since the FCFF is the cash available to all the investors, the after-tax weighted average cost of capital should be used as the discount rate in FCFF models.
4. In the stable-growth FCFE model, an extremely low value can result from all of the following EXCEPT:
A) capital expenditures are too high relative to depreciation.
B) the required rate of return is too high for a stable firm.
C) the expected growth rate is too high for a stable firm.
Explanation: (C) If the expected growth rate is too high for a stable firm, the value obtained using the stable-growth FCFE model will be extremely high.
5. 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 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.
B) The cost of equity estimate in the stable growth period is too high for a stable firm.
C) Earnings are temporarily depressed because of a one-time extraordinary accounting charge in the most recent fiscal year.
Explanation: (A) 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.
6. Free cash flow (FCF) approaches are the best source of value when:
A) a firm is paying a dividend that is higher than the industry average.
B) a firm has preferred stock.
C) FCFs track profitability closely over the analyst’s forecast horizon.
Explanation: (C) FCF approaches are best when those flows are a good indication of a firm’s profitability over the analyst’s forecast horizon.
7. What is the most likely reason that you get an extremely low value from the three-stage FCFE model? Capital expenditures are significantly:
A) less than depreciation during the high-growth phase.
B) higher than depreciation during the high-growth phase.
C) higher than depreciation in the stable-growth phase
Explanation: (C) If capital expenditures estimates are significantly higher than depreciation for the stable growth period, then the three-stage FCFE model might result in an extremely low value. One possible solution for the problem is to grow the capital expenditures more slowly than deprecation in the transition period to narrow the difference. Another is to assume that capital expenditures and depreciation will offset when growth normalizes.
8. When using the two-stage FCFE model, if increases in working capital appear too high the analyst should:
A) normalize them to be equal to zero.
B) switch to a three-stage model.
C) use changes that are based upon a working capital ratio that is closer to the industry average.
Explanation: (C) 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.
9. 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.
Explanation: (A) Free cash flow approaches are best when dividends are not paid. Both remaining responses have nothing to do with the decision.
10. Free cash flow (FCF) approaches are the best source of value when:
A) a firm has no preferred stock.
B) dividends are paid but do not reflect the company’s capacity to pay dividends.
C) a firm has significant minority interest.
Explanation: (B) 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.
