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 willmaximize 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 – taxrate) + 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 occurredbecause: FCFE = FCFF – [interest expense] (1 – tax rate) + netborrowing 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. Noticethe 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 theﬁrm'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 bankruptcyrisk will be low, and will be more than offset by the additional value ofinterest 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 toradically change the dividend payout policy while FCFE often hasimmense variability. B) Companies often use FCFE as a signal of positive future growthprospects 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 viewedas 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 dodividend discount models (DDMs).
B) Required returns are higher in FCFE discount models than they arein 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 theshareholders, 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 thediscretion of the ﬁrm. Dividends can be equal to, lower or higher thanFCFE. For example, sometimes ﬁrms may pay dividends in years whenthere 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