CFA Practice Question

There are 201 practice questions for this study session.

CFA Practice Question

Which of the following statements is (are) true with respect to the recognition of value in the free cash flow to equity (FCFE) model relative to the dividend discount model (DDM)?

I. If the investor will be exercising a heavily influence on the company's decisions, than the DDM would be more appropriate in valuing the company.
II. For new and growing enterprises, the FCFE would be a better benchmark to discount than dividends.
III. FCFE can be influenced by such things as new share issues, whereas dividends are only ultimately derived from earnings.
IV. If a company has no net borrowing over a period, then its EBITDA may be used as a substitute for its FCFE.
Correct Answer: II

I is incorrect because if the investor will be exercising a heavily influence on the company's decisions, that means he can control the company's entire free cash flows, not just the part that's earmarked for dividend payments. Hence, the FCFE model would be more appropriate.

III is incorrect because FCFE does not take into account proceeds that become available from new stock issues, therefore, it will not be influenced by such a transaction.

IV is incorrect because EBITDA is a before tax item, whereas FCFE is an after-tax item. EBITDA ignores the tax shields are created by non-cash expenses, thus producing unrealistic measures of cash flow.

User Contributed Comments 5

User Comment
ssradja IV. Also EBITDA is not net of capital expenditures.
surjoy Net Borrowing that include new issues will influence FCFE. Then why III is incorrect?
DAPC You are not borrowing when you issue shares. You are capitalizing the company. Net borrowing only accounts for Debt issuance/payments. (or so that is how i see it).
weiw Why II is correct? FCF model can not be used for growing company according to the note. Maybe it's better than dividend since such companies don't typically issue dividends but still produce cash flows?
JohnnyWu I figured DDM and FCF are equally bad for valuing new and growing companies. Most do not pay dividends and could have negative FCF due to high capex.
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