Free Cash Flow and Residual Income Valuation

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1 Free Cash Flow and Residual Income Valuation Question L (1) The impact of firm lowering its forecasted debt ratio on the forecasted Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE) would most likely be: a. A lower free cash flow to the firm but no change to free cash flow to equity. b. No changes to both. c. No change to free cash flow to the firm but a lower free cash flow to equity. Question L A (2) firm calculated that if it were to use accelerated depreciation instead of straight line depreciation for new equipment next year, depreciation expense would increase by $1,000. Assuming a 30% tax rate, the change in forecasted Free Cash Flow to the Firm would be closest to: a. An increase of $700. b. An increase of $300. c. A decrease of $700. Question L (3) For 20X1, XYZ Corp. reported interest expense of $100,000, taxes of $300,000, selling expenses of $400,000, depreciation and amortization of $50,000, and net income of $700,000. The company's net working assets rose by $75,000 and the firm spent $60,000 on capital expenditures. Calculate the free cash flow to the firm. a. $405,000 b. $685,000 c. $755,000 1

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3 (4) Robert plans to value BPT using both free cash flow approaches. BPT s FCFF and FCFE for the year ending June 30, 20X5 are closest to: FCFF FCFE a. ($3.9 mil) $6.0 mil b. $9.1 mil $19.0 mil c. $13.1 mil $23.0 mil (5) Robert has decided to use FCFE to value BPT. He has made several adjustments and has projected FCFE to be $18 million for the year ending June 30, 20X6. He still believes that PBT will achieve 8% growth in 20X7 and then fall to a long-term growth rate of 3%. He believes the best approach to finding terminal value is to use the Gordon growth model modified to work with free cash flow. Which of the following best estimates the per share value using a two-stage free cash flow to equity (FCFE) valuation? a. $14.01 b. $15.65 c. $17.08 (6) Robert s boss asks why he did not use FCFF instead of FCFE in his valuation. Also, he questioned on why he didn t use a DDM. Robert states reasons for his choice of a FCFE valuation. Choose which of these is a valid justification for his choice. a. FCFE can be calculated for non-dividend paying firms, while FCFF cannot be calculated for these firms. b. When a firm has a stable capital structure, FCFE is more direct and easier to use than FCFF. c. FCFE will have a more stable growth rate than FCFF for a firm with a history of leverage changes. 3

4 Question L XYZ Company Balance Sheets ($) 12/31/20X0 12/31/20X1 Cash $100,000 $180,000 Accounts Receivable - 70,000 Inventory 50,000 50,000 Net Fixed Assets 400, ,000 Total Assets $550,000 $750,000 Accounts Payable $ 40,000 $ 90,000 Long-term Debt 400, ,000 Contributed Capital 110, ,000 Retained Earnings - 150,000 Total Liab. & Equity $550,000 $750,000 Income Statement ($) 12/31/20X1 Sales $500,000 Cost of Goods Sold (200,000) Depreciation (20,000) Earning Before Interest & Taxes 280,000 Interest (30,000) Pretax Income 250,000 Taxes (100,000) Net Income $150,000 Other information: In 20X1, XYZ Company sold no fixed assets. XYZ's long-term debt comes due in five years and no principal payments were made in 20X1. (7) Based on the above financial information, XYZ Company's free cash flow to the firm in 20X1 is closest to: a. $80,000 b. $98,000 c. $118,000 4

5 Question L One of the companies that Jones is researching is Mackinac, Inc., a U.S.-based manufacturing company. Mackinac has released its June 20X1 financial statements, which are shown in Exhibits 2-1, 2-2 and 2-3. Exhibit 2-1 Mackinac, Inc. Income Statement for the Year ended June 30, 20X1 (in thousands, except per-share data) Sales $250,000 Cost of Goods Sold 125,000 Gross Operating Profit $125,000 Selling, General, and Administrative Expenses 50,000 Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) $ Depreciation and Amortization $ 10,500 Earnings Before Interest and Taxes (EBIT) $ 64,500 Interest Expense 11,000 Pretax Income $ 53,500 Income Taxes 16,050 Net Income $ 37,450 Shares Outstanding 13,000 Earnings Per Share (EPS) $ 2.88 Exhibit 2-2 Mackinac, Inc. Balance Sheet As of June 30, 20X1 (in thousands) Current Assets: Cash and Equivalents $20,000 Receivables 40,000 Inventories 29,000 Other Current Assets 23,000 Total Current Assets $112,000 Non-current Assets: Property, Plant, and Equipment $155,000 Less: Accumulated Depreciation (53,500) Net Property, Plant, and Equipment $102,000 Investments 70,000 Other Non-current Assets 36,000 Total Non-current Assets $208,000 Total Assets $320,000 Current Liabilities: Accounts Payable $41,000 Short-term Debt 12,000 Other Current Liabilities 17,000 Total Current Liabilities $70,000 Non-current Liabilities: Long-term Debt $100,000 Total Non-current Liabilities $100,000 Total Liabilities $170,000 Shareholders' Equity Common Equity $40,000 Retained Earnings 110,000 Total Equity $150,000 5

6 Total Liabilities and Equity $320,000 Exhibit 2-3 Mackinac, Inc. Cash Flow Statement for the Year ended June 30, 20X1 (in thousands) Cash Flow from Operating Activities: Net Income $37,450 Depreciation and Amortization 10,500 Change in Working Capital: (Increase) Decrease in Receivables ($5,000) (Increase) Decrease in Inventories (8,000) Increase (Decrease) in Payables 6,000 Increase (Decrease) in Other Current Liabilities 1,500 Net Change in Working Capital $ (5,500) Net Cash from Operating Activities $42,450 Cash Flow from Investing Activities: Purchase of Property, Plant, and Equipment ($15,000) Net Cash from Investing Activities ($15,000) Cash Flow from Financing Activities: Change in Debt Outstanding $4,000 Payment of Cash Dividends (22,470) Net Cash from Financing Activities ($18,470) Net Change in Cash and Cash Equivalents $8,980 Cash at Beginning of Period 11,020 Cash at End of Period $20,000 Mackinac has announced that it has finalized an agreement to handle North American production of a successful product currently marketed by a foreign company. Jones decides to value Mackinac using the dividend discount model (DDM) and the free cash flow-to-equity (FCFE) model. After reviewing Mackinac's financial statements in Exhibits 2-1, 2-2 and 2-3 and forecasts related to the new production agreement, Jones concludes the following: Mackinac's earnings and FCFE are expected to grow 17% per year over the next three years before stabilizing at an annual growth rate of 9%. Mackinac will maintain the current payout ratio. Mackinac's beta is The government bond yield is 6% and the market equity premium is 5%. Note: Use June 30, 20X1 year-end balance sheet data rather than averages in ratio calculations. What is the value of a share of Mackinac's common stock using the two-stage FCFE model? a. $99.77 b. $89.74 c. $

7 Question L From KAS Company's balance sheets for 20X1 and 20X2, we find the following information: 20X1 20X2 Total Assets $80,000 $95,000 Common Equity 20,000 25,000 Deferred Tax Liabilities 4,000 5,000 Bank Loans 45,000 50,000 The company uses FIFO method for inventories and has no accounts receivable (and related bad debt reserve). Using the price of the publicly traded shares, the market value of the common equity was $30,000 in 20X1 and $32,000 in 20X2. The market values of the deferred tax liabilities and bank loans are equal to their book values. The total assets are estimated to have market values of $90,000 and $102,000 for 20X1 and 20X2, respectively. Based on this information, calculate the change in the market value added (MVA) for 20X2 relative to 20X1. a. $(3,000) b. $7,000 c. $8,000 7

8 Question L Porfirio Rubirosa, CFA, analyzes firms from a residual income perspective for RBP Analytics Group. Rubirosa has gathered the following information regarding Floating Point Router Corporation (FPRC). FPRC Balance Sheet for Fiscal Year Ended 7/31/20X4 ($ millions) 20X3 20X4 Current assets $13,437 14,343 Property, plant & equipment - net 29,279 33,251 Total Assets $42,716 $47,594 Current liabilities $ 8,294 $ 8,703 Long-term debt 12,774 12,975 Shareholders' equity 21,648 25,916 Total Liabilities and Equity $42,716 $47,594 FPRC Income Statement for Fiscal Year Ended 7/31/20X4 (All amounts are millions except per share data) 20X3 20X4 Net Sales $18,878 $22,045 Cost of Goods Sold 5,645 6,935 Operating Expenses 7,151 7,634 Interest Expenses 1,200 1,200 Taxes (32% tax rate) 1,562 2,008 Net Income $ 3,320 $ 4,268 Common Shares Outstanding 6,840 6,840 Earnings per share $0.47 $0.62 Rubirosa has gathered the following additional information: FPRC's cost of equity capital (using CAPM) is 12%. The Company is working on a new project, code name Project X. If Project X goes online, the contract will result in the firm achieving a return on equity of 25% during the project's life. If Project X does not occur, the firm's current ROE is expected to remain constant and the firm's longterm residual income growth rate is expected to be 4%. At December 31, 20X4, the firm has 6,840 million common shares outstanding. The Company does not pay any dividends at this time. If Project X is undertaken, no dividends will be paid for the next three years. If Project X is not undertaken, the firm expects to start paying a dividend in 20X5. Without Project X, the expected dividend payout will be 80% in 20X5 and thereafter. Rubirosa now believes that Project X will come online and the firm's ROE will rise to 25% during the period that the project is online. At the end of the three years, the shares are expected to trade at a price-to-book value (P/BV) multiple of 3.0. The value per share for the firm based on a residual income model with a finite horizon is closest to: a. $14.55 b. $15.80 c. $