CFA Level 2 - Equity Session 12 - Reading 43 Free Cash Flow Valuation - LOS g

CFA Level 2 - Equity Session 12-Reading 43 Free Cash Flow Valuation - LOS g (Practice Questions, Sample Questions) 1. Optimal capital structure is the mix of debt and equity that will maximize the value of the firm and minimize: A) weighted average cost of capital (WACC). B) interest expense. C) weighted average cost of equity. Explanation: (A) The optimal capital structure is the mix of debt and equity that will maximize the value of the firm and minimize the WACC 2. 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 Explanation: (A) Debt repayment will decrease net borrowing and, hence, decrease FCFE because: FCFE = FCFF – [interest expense] (1 – tax rate) + net borrowing. 3. 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 Explanation: (A) 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 4. 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 Explanation: (A) 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. 5. 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) dividend payments. C) debt principal repayments. Explanation: (B) A firm’s FCFE is the cash available to stockholders after funding capital expenditures and debt principal repayments. 6. 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) no change in firm value. C) an increase in value due to interest tax shields. Explanation: (C) 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. 7. In what ways are dividends different from free cashflow to equity (FCFE)? A) Dividends are often viewed as "sticky." Managers are reluctant to radically change the dividend payout policy while FCFE often has immense variability. B) Companies often use FCFE as a signal of positive future growth prospects while dividends are not used for signaling. C) There is no difference. Dividends must equal FCFE. Explanation: (A) Dividends and the FCFE are often different and dividends are used as a signal to the market not FCFE. Dividends viewed as sticky is the true statement 8. Which of the following statements regarding dividends and free cash flow to equity (FCFE) is least accurate? A) FCFE discount models usually result in higher equity values than do dividend discount models (DDMs). B) Required returns are higher in FCFE discount models than they are in dividend discount models, since FCFE is more difficult to estimate. C) FCFE can be negative but dividends cannot Explanation: (B) Although FCFE may be more difficult to estimate than dividends, the required return is based on the risk faced by the shareholders, which would be the same under both models 9. Dividends paid out to the shareholders: A) are always equal to free cash flow to equity (FCFE). B) are always less than free cash flow to equity (FCFE). C) may be higher than free cash flow to equity FCFE Explanation: (C) Dividends represent the cash that the firm chooses to pay to the shareholders and the amount of the dividend is subject to the discretion of the firm. Dividends can be equal to, lower or higher than FCFE. For example, sometimes firms may pay dividends in years when there is a net loss 10. Which of the following is least likely to change as the firm changes leverage? A) Free cash flows to firm (FCFF). B) Free cash flows to equity (FCFE). C) Weighted average cost of capital (WACC) Explanation: (A) The FCFFs are normally unaffected by the changes in leverage, as these are the cash flows before the debt payments