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

CFA Level 2 - Equity Session 12-Reading 43 Free Cash Flow Valuation - LOS c (Practice Questions, Sample Questions) 1. The following information is derived from the financial records of Brown Company for the year ended December 31, 2004: Sales$3,400,000 Cost of Goods Sold (COGS)(2,100,000) Depreciation(300,000) Interest Paid(200,000) Gain on Sale of Old Equipment400,000 Income Taxes Paid(300,000) Net Income$900,000

Brown issued bonds on June 30, 2004 and received proceeds of$4,000,000.Old equipment with a book value of $2,000,000 was sold on August 15,2004 for $2,400,000 cash.Brown purchased land for a new factory on September 30, 2004 for$3,000,000, issuing a $2,000,000 note and paying the balance in cash.Cash flow from operations less capital expenditures is: A) $2,200,000. B) $200,000.C) $6,200,000. <Explanation> A) Brown’s cash flow from operations (CFO) was $800,000 = ($900,000 Net Income + $300,000 depreciation ?$400,000 gain).Capital expenditure cash flows were ?$1,000,000 for the factory and$2,400,000 cash received from sale of the old equipment for a netinflow of cash of $1,400,000.$2,200,000 = ($800,000 + $1,400,000) 2. Free cash flow to the firm (FCFF) adjusts earnings before interest and taxes (EBIT) by: A) subtracting investments in fixed capital and working capital. B) deducting taxes, adding back depreciation, and deducting theinvestments in fixed capital and working capital. C) adding taxes, deducting depreciation, and adding back theinvestments in fixed capital and working capital <Explanation> B) As presented in the reading: FCFF = EBIT (1 – tax rate) + Dep – FCInv – WCInv.

3. In computing free cash flow, the most significant non-cash expense is usually: A) deferred taxes.B) capital expenditures. C) depreciation. <Explanation> C) Depreciation is usually the largest non-cash expense. 4. Which of the following items is NOT subtracted from the net income to calculate free cash flow to equity (FCFE)? A) Interest payments to bondholders. B) Subtractions to notes payable.C) Additions to cash. <Explanation> A) Interest payments to bondholders are included in the income statement and are already subtracted to calculate netincome.