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Free Cash Flow Question No.1: For Exam Preparation

The document contains 8 practice questions related to financial strategy and policy. The questions cover topics such as estimating firm value using free cash flow models, calculating weighted average cost of capital, and forecasting additional funds needed.

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NAFEES NASRUDDIN PATEL
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129 views16 pages

Free Cash Flow Question No.1: For Exam Preparation

The document contains 8 practice questions related to financial strategy and policy. The questions cover topics such as estimating firm value using free cash flow models, calculating weighted average cost of capital, and forecasting additional funds needed.

Uploaded by

NAFEES NASRUDDIN PATEL
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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For exam preparation

FINANCIAL STRATEGY AND POLICY (Thursday 6.30 till 9.30)

Free Cash Flow


Question No.1
Estimate the value of a firm’s equity (P0) whose cash flow is projected to grow at a
compound annual average growth rate of 15% for the next five years. The
current year’s cash flow is $3.00 million. The firm’s cost of capital during the high
growth period is 12%. The sustainable growth rate and cost of capital during the
terminal period are 5% and 8%, respectively. The market value of the firm’s
current outstanding debt is $6 million.
Question No.2
The CEO of Buffalo Bob’s Chicken Wings is considering selling his firm.
She estimates that the firm’s current year equity cash flow is $4 million.
She asks her CFO to create several estimates of the firm’s value. Scenario
1 is to be based on a 4% annual growth rate; the second scenario is to
reflect a 6% annual growth rate for the next five years and 3% thereafter.
The firm’s cost of equity for both scenarios is estimated to be 10%. What is
the value of the firm under scenario 1 and scenario 2?
Question No.3
Sematech has achieved a dominant market position in its targeted market. Its
huge market share makes it unlikely that the firm can grow faster than the growth
rate of the overall market, which is expected to be 8% annually through the
foreseeable future. Its net income in 2013 was $15 million. Depreciation expense
and capital expenditures were $5 million and $10 million, respectively. The annual
change in working capital was minimal. The 10-year Treasury bond rate was 5%
and the firm’s beta was estimated to be 1.3. The historical risk premium on
stocks over the risk free rate of return is 5.5%.
1.  Calculate Sematech’s discount rate.
2. Calculate the firm’s free cash flow in 2013.
3. Estimate the value of Sematech at the end of 2013.
Question No.4
A firm’s cost of equity and preferred stock are estimated to be 9.5% and 6.5%,
respectively. The firm’s cost of debt and marginal tax rate are 6% and 40%,
respectively. The market values of the firm’s common and preferred equity are
$870 million and $120 million, respectively. The market value of the firm’s debt is
$250 million. What is the firm’s weighted average cost of capital?
Exercises-Financial Planning
Question No.5
Baxter Video Products' sales are expected to increase by 20% from $5 million in
2010 to $6 million in 2011. Its assets totaled $3 million at the end of 2010. Baxter
is already at full capacity, so its assets must grow at the same rate as projected
sales. At the end of 2010, current liabilities were $1 million, consisting of
$250,000 of accounts payable, $500,000 of notes payable, and $250,000 of
accruals. The aftertax profit margin is forecasted to be 5%, and the forecasted
payout ratio is 70%. Use the AFN equation to forecast Baxter’s additional
funds needed for the current year?
Question No.6
Refer to Problem 12-1. What would be the additional funds needed if the
company’s
year-end 2010 assets had been $4 million? Assume that all other numbers,
including sales, are the same as in Problem 12-1 and that the company is
operating at full capacity. Why is this AFN different from the one you found in
Problem 12-1? Is the company’s “capital intensity” ratio the same or different?
Question No.7
Refer to Problem 12-1. Return to the assumption that the company had $3 million
in
assets at the end of 2010, but now assume that the company pays no dividends.
Under these assumptions, what would be the additional funds needed for the
coming year? Why is this AFN different from the one you found in Problem 12-1?
Question No.8
Bannister Legal Services generated $2,000,000 in sales during 2010, and its year-
end total assets were $1,500,000. Also, at year-end 2010, current liabilities were
$500,000, consisting of $200,000 of notes payable, $200,000 of accounts payable,
and $100,000 of accruals. Looking ahead to 2011, the company estimates that its
assets must increase at the same rate as sales, its spontaneous liabilities will
increase at the same rate as sales, its profit margin will be 5%, and its payout ratio
will be 60%. How large a sales increase can the company achieve without having
to raise funds externally; that is, what is its self-supporting growth rate
Question No.9
The Barnsdale Corporation has the following ratios: A0*/S0 = 1.6; L0*/S0 = 0.4;
profit
margin = 0.10; and dividend payout ratio = 0.45, or 45%. Sales last year were $100
million. Assuming that these ratios will remain constant, use the AFN equation to
determine the firm’s self-supporting growth rate—in other words, the maximum
growth rate Barnsdale can achieve without having to employ nonspontaneous
external funds
Zero Growth Model
What is the value of a firm, whose annual FCFF0 of $1 million is expected to
remain constant in perpetuity and whose weighted average cost of capital is
12%.
Constant Growth Model Example
Cash flow next year (i.e., FCFF1, the first year of the forecast period) is
expected to grow at a constant rate.
FCFF1=FCFF0(1+g)
P0 = FCFF1 / (WACC-g), where g is the expected rate of growth of FCFF 1.
P0 = FCFE1 / (ke –g), where g is the expected rate of growth of FCFE 1.

Estimate the value of a firm (P 0) whose cost of equity is 15% and whose cash
flow in the prior year is projected to grow 20% in the current year and then at
a constant 10% annual rate thereafter. Cash flow in the prior year is $2
million.
Variable Growth Model Example
Estimate the value of a firm (P0) whose cash flow is projected to grow at a
compound annual average rate of 35% for the next five years and then assume
a more normal 5% annual growth rate. The current year’s cash flow is $4
million. The firm’s weighted average cost of capital during the high growth
period is 18% and then drops to the industry average rate of 12% beyond the
fifth year.

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