University:
CFA Institute
Course:
CFA Level 2 - Equity
Academic year:

2023
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23

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7
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anon

CFA Level 2 - Equity Session 12-Reading 43 Free Cash Flow Valuation - LOS j (Practice Questions, Sample Questions) 1. Industrial Light currently has: Free cash flow to equity = $4.0 million. Cost of equity = 12%. Weighted average cost of capital = 10%. Total debt = $30.0 million. Long-term expected growth rate = 5%. What is the value of equity? A) $57,142,857. B) $27,142,857. C) $60,000,000. : The value of equity is [($4,000,000)(1.05) / (0.12 – 0.05)] = $60,000,000 2. Starshah Industries competes in a high-growth, emerging technology sector that is facing increasing competitive pressures. So far, the firm has been performing well, earning $4.55 per share in 2004. Investment requirements were high, with capital expenditures of $1.75 per share, depreciation expense of $1.05, and a net investment in working capital that year of $1.00 per share. However, despite Starshah’s high growth rate and impressive profitability, Starshah’s Chairman, Lorenzo di Stefano, has become concerned about the impact that a slowdown in expected growth may have on the firm’s valuation. Di Stefano asked Starshah’s Director of Strategic Planning, Keisha Simmons, to make a presentation to Starshah’s board at the end of 2004 about the future growth of the firm. The news was sobering. Simmons told the board members that Starshah could expect two more years of rapid growth, during which time earnings per share could be expected to rise 45% per year with 30% annual increases in capital spending and depreciation. During this high-growth period, Simmons estimates that the required return on equity for Starshah will be 25%. Starshah consistently maintains a target debt ratio of 0.25. After the near-term spurt of high growth, however, she and her group expect Starshah to move eventually to a stable growth period. During the stable growth period, free cash flow to equity (FCFE) will rise only 5% per year and the annual return to shareholders will decline to 10%. The strategy group expects the transitional period between high-growth and mature growth to last five years. During that time, capital expenditures will rise only 8% per year, with depreciation rising 13% per year. The growth in earnings should drop by eight percentage points per year, hitting 5% in the fifth year. During this transition, the expected return to shareholders will be 15% per year. Throughout the high-growth and transitional growth periods, Simmons expects Starshah to be able to limit increases in the investment in working capital to 20 cents per year. In her analysis, the investment in working capital will peak in 2010, declining a dime to $2.10 per share in 2011. After Simmons’ presentation, the board debated what to do about the incipient slowdown in Starshah’s growth. A majority of the board argued in favor of moving to offset this slowdown in organic growth through a new emphasis on growth by acquisition. One potential target is TPX. TPX's current and expected FCFE: $425,000 in 2004, $500,000 in 2005, $600,000 the following year, and $700,000 in 2007. After that, Starshah expects FCFE at TPX to grow 3% per year indefinitely. Starshah would require a return on its equity investment of 20% per year in the high-growth stage and 12% per year in the stable growth stage. Di Stefano and Simmons had a somber meeting the day after the board presentation. But despite the bleak news about future years, di Stefano had convinced himself it was worth staying around through the high-growth and transitional periods. He pointed out to Simmons that, if Simmons’ projections were correct, the value of Starshah’s stock would be in excess of $450 per share by the time the company hit the stable-growth phase. Di Stefano was very pleased with what that implied for the value of his stock options. Simmons had done the same calculations herself, but she also realized that if required rates of return in 2012 rose from the very modest 10% she used in her board projections to only 15%, that would cut the terminal value of Starshah’s stock in 2011 to only half the level di Stefano was counting on. She considered that valuation too small to make the wait worthwhile. Simmons said nothing to di Stefano, but planned to look for another job. Which of the following FCFE models is best suited to analyzing TPX? A) Two-stage FCFE model. B) Stable growth FCFE model. C) Three-stage FCFE model : The two-stage FCFE model is most suited to analyzing TPX because we have specific forecasts for the first several years and then a stable growth pattern into the indefinite future. 3. The value of stock under the two-stage FCFE model will be equal to: A) present value (PV) of FCFE during the extraordinary growth period plus the terminal value. B) present value (PV) of FCFE during the extraordinary growth period plus the PV of terminal value. C) present value (PV) of FCFE during the extraordinary growth and transitional periods plus the PV of terminal value. : The value of stock under the two-stage FCFE model will be equal to the present value of FCFE during the extraordinary growth period plus the present value of the terminal value at the end of this period. 4. A firm's free cash flow to equity (FCFE) in the most recent year is $50M and is expected to grow at 5% per year forever. If its shareholders require a return of 12%, the value of the firm's equity using the single-stage FCFE model is: A) $417M. B) $750M. C) $714M. : The value of the firm's equity is: $50M × 1.05 / (0.12 ? 0.05) = $750M 5. 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. In year 1, what is the forecasted free cash flow to equity (FCFE) for TOY, Inc.? A) $3.56. B) $4.53. C) $4.31. : Earnings = 5 × 1.05 = 5.25, capital expenditures = 2.4 × 1.05 = 2.52, deprecation = 1.8 × 1.05 = 1.89, change in working capital = 1.7 × 1.05 = 1.785, FCFE = Earnings per share ? (Capital Expenditures ? Depreciation)(1 ? Debt Ratio) ? (Change in working capital)(1 ? Debt Ratio) = 5.25 ? (2.52 ? 1.89)(1 ? 0.3) ? (1.785)(1 ? 0.3) = 3.56 6. What is the value of TOY, Inc.'s, stock given the above assumptions? A) $50.86. B) $61.57. C) $64.71 : The value of the stock = FCFE1 / (r ? gn) = 3.56 / (0.12 ? 0.05) = 50.86. 7. Industrial Light currently has: Expected free cash flow to the firm in one year = $4.0 million. Cost of equity = 12%. Weighted average cost of capital = 10%. Total debt = $30.0 million. Long-term expected growth rate = 5%. What is the value of equity?> > A) $80,000,000. B) $44,440,000. C) $50,000,000. : The overall value of the firm is $4,000,000 / (0.10 – 0.05) = $80,000,000. Thus, the value of equity is $80,000,000 – $30,000,000 = $50,000,000. 8. A firm has projected free cash flow to equity next year of $1.25 per share, $1.55 in two years, and a terminal value of $90.00 two years from now, as well. Given the firm’s cost of equity of 12%, a weighted average cost of capital of 14%, and total outstanding debt of $30.00 per share, what is the current value of equity? A) $41.54. B) $71.74. C) $74.10. : Value of equity = $1.25 / (1.12)1 + $1.55 / (1.12)2 + $90.00 / (1.12)2 = $74.10

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

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