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. <Explanation>: 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 competitivepressures. 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, depreciationexpense of $1.05, and a net investment in working capital thatyear of $1.00 per share. However, despite Starshah’s high growthrate and impressive proﬁtability, Starshah’s Chairman, Lorenzo
di Stefano, has become concerned about the impact that aslowdown 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 atthe end of 2004 about the future growth of the ﬁrm. The newswas sobering. Simmons told the board members that Starshahcould expect two more years of rapid growth, during which timeearnings per share could be expected to rise 45% per year with30% annual increases in capital spending and depreciation.During this high-growth period, Simmons estimates that therequired return on equity for Starshah will be 25%. Starshahconsistently maintains a target debt ratio of 0.25.After the near-term spurt of high growth, however, she and hergroup expect Starshah to move eventually to a stable growthperiod. During the stable growth period, free cash ﬂow to equity(FCFE) will rise only 5% per year and the annual return toshareholders will decline to 10%. The strategy group expects the transitional period betweenhigh-growth and mature growth to last ﬁve years. During thattime, capital expenditures will rise only 8% per year, withdepreciation rising 13% per year. The growth in earnings shoulddrop by eight percentage points per year, hitting 5% in the ﬁfthyear. During this transition, the expected return to shareholderswill be 15% per year.Throughout the high-growth and transitional growth periods,Simmons expects Starshah to be able to limit increases in theinvestment in working capital to 20 cents per year. In heranalysis, 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 doabout the incipient slowdown in Starshah’s growth. A majority of
the board argued in favor of moving to o set this slowdown inorganic growth through a new emphasis on growth byacquisition.One potential target is TPX. TPX's current and expected FCFE:$425,000 in 2004, $500,000 in 2005, $600,000 the followingyear, and $700,000 in 2007. After that, Starshah expects FCFE atTPX to grow 3% per year indeﬁnitely. Starshah would require areturn on its equity investment of 20% per year in thehigh-growth stage and 12% per year in the stable growth stage. Di Stefano and Simmons had a somber meeting the day after theboard presentation. But despite the bleak news about futureyears, di Stefano had convinced himself it was worth stayingaround through the high-growth and transitional periods. Hepointed out to Simmons that, if Simmons’ projections werecorrect, the value of Starshah’s stock would be in excess of $450per share by the time the company hit the stable-growth phase.Di Stefano was very pleased with what that implied for the valueof his stock options.Simmons had done the same calculations herself, but she alsorealized that if required rates of return in 2012 rose from the verymodest 10% she used in her board projections to only 15%, thatwould cut the terminal value of Starshah’s stock in 2011 to onlyhalf the level di Stefano was counting on. She considered thatvaluation too small to make the wait worthwhile. Simmons saidnothing to di Stefano, but planned to look for another job. Which of the following FCFE models is best suited to analyzingTPX? A) Two-stage FCFE model. B) Stable growth FCFE model.C) Three-stage FCFE model
<Explanation>: The two-stage FCFE model is most suited to analyzing TPX because we have speciﬁc forecasts for the ﬁrstseveral years and then a stable growth pattern into the indeﬁnitefuture. 3. The value of stock under the two-stage FCFE model will be equal to: A) present value (PV) of FCFE during the extraordinary growthperiod plus the terminal value. B) present value (PV) of FCFE during the extraordinary growthperiod plus the PV of terminal value. C) present value (PV) of FCFE during the extraordinary growthand transitional periods plus the PV of terminal value. <Explanation>: The value of stock under the two-stage FCFE model will be equal to the present value of FCFE during theextraordinary growth period plus the present value of theterminal 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 itsshareholders require a return of 12%, the value of the ﬁrm'sequity using the single-stage FCFE model is: A) $417M. B) $750M. C) $714M. <Explanation>: 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 0Earnings $5.00Capital Expenditures $2.40Depreciation $1.80Change in Working Capital $1.70 TOY, Inc.'s, target debt ratio is 30% and has a required rate ofreturn of 12%. Earnings, capital expenditures, depreciation, andworking capital are all expected to grow by 5% a year in thefuture. 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. <Explanation>: Earnings = 5 × 1.05 = 5.25, capital expenditures = 2.4 × 1.05 = 2.52, deprecation = 1.8 × 1.05 = 1.89, change inworking capital = 1.7 × 1.05 = 1.785, FCFE = Earnings per share ?(Capital Expenditures ? Depreciation)(1 ? Debt Ratio) ? (Change inworking 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 <Explanation>: 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. <Explanation>: 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 twoyears from now, as well. Given the ﬁrm’s cost of equity of 12%, aweighted average cost of capital of 14%, and total outstandingdebt of $30.00 per share, what is the current value of equity? A) $41.54.B) $71.74.
C) $74.10 . <Explanation>: Value of equity = $1.25 / (1.12)1 + $1.55 / (1.12)2 + $90.00 / (1.12)2 = $74.10