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 issues associated with using free cash flow measures to valuate a company?

I. Free cash flow to the firm (FCFF) can be used to calculate the value of the firm to equity.
II. Companies that constantly change their capital structure may be more properly valued by using its free cash flow to equity (FCFE) as the proxy for cash flow.
III. If a company did not have any debts, its FCFE would simply be equal to its reported cash flow from operations (CFO).
IV. The weighted average cost of capital may only be used to discount the firm's FCFF.
Correct Answer: I and IV

I is true because FCFF may first be used to calculate the total value of the firm. However, by simply deducting the market value of the debt from the total value, one may derive the equity value.

II is incorrect because companies that constantly change their capital structure will have a very erratic FCFE, as this is the net cash flow after payments have been exchanged with bondholders. Consequently, the company may be more properly valued by using its FCFF as the proxy for cash flow.

III is incorrect because even if a company did not have any debts, its FCFE would be equal to its reported cash flow from operations minus any expenditures in plant and equipment in order to maintain it growth rate. Hence, the norm is for debt free firm to have a FCFE that is lower than CFO.

User Contributed Comments 3

User Comment
jmcarr02 IV. FCFE cannot be discounted using WACC. One should use required rate of return on equity (r) to discount FCFE.
prabhur08 I think II is true. If a company's capital structure is changing, using FCFF will not solve the issue as the WACC used to discount FCF assumes a constant capital structure. If we can forecast the pay down of debt and debt level over time, then FCFE will provide the better picture. The issue we will have to take care of is recalculating the cost of equity for each period based on the leverage for that period i.e. using an appropriately levered beta to calculate cost of equity.
davidt876 i see what ur saying prabhur - but in your work around you still have to assume that the capital structure is constant in the proportion of D/E that you used to calculate the levered beta.

the real issue the question is getting at: large inflows and outflows of debt will make FCFE more volatile, and so using FCFE to value the company will result in spuriously high and low valuations from year to year.

if you did want to use FCFE i think the best solution would be to analyze debt maturities in the FS notes, read up on the companies capital investment plans and look at projected CFO (maybe even look at their investment portfolio and expected market performance). you might be able to piece together an idea of whether they will allow (or can afford to allow) maturing debt to drop off the books (effect of FCFE) or look to refinance the debt (no effect on FCFE). or if they will need to issue more debt (effect on FCFE). then you could forecast D/E and lever your beta appropriately in future periods. but at this point why not use that information to better forecast your WACC in future periods and go back to using the FCFF which is less volatile?
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