Free Cash Flow to Equity Practice

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Questions and Answers

In a DCF valuation, what is the primary purpose of estimating the cost of capital?

To determine the discount rate for cash flows

Which of the following is a consideration when estimating cash flows for a DCF valuation?

Future expectations and forecasted growth

What is the difference between nominal and real cash flows?

Nominal cash flows are in current dollars, real cash flows are in constant dollars

What is the primary purpose of estimating a terminal growth rate in a DCF valuation?

To forecast cash flows beyond the explicit forecast period Signup and view all the answers

When estimating the cost of capital, which of the following is NOT a factor to consider?

Historical financial performance Signup and view all the answers

Which of the following would be used to estimate the discount rate in a DCF valuation?

Weighted average cost of capital (WACC) Signup and view all the answers

What is the primary advantage of using a DCF valuation?

It is based on future expected cash flows Signup and view all the answers

When estimating cash flows for a DCF valuation, which of the following should be excluded?

Financing cash flows Signup and view all the answers

What is the terminal growth rate of Darden Restaurants, Inc (DRI) expected to be?

3.8% Signup and view all the answers

When estimating cash flow to equity, which earnings should be considered?

Earnings after interest expenses Signup and view all the answers

What is the purpose of estimating the cost of capital in a discounted cash flow model?

To determine the discount rate Signup and view all the answers

What is the main difference between nominal and real cash flows?

Nominal cash flows include inflation, while real cash flows do not Signup and view all the answers

What is the purpose of estimating cash flow in a discounted cash flow model?

To calculate the present value of future cash flows Signup and view all the answers

When estimating cash flow to the firm, which earnings should be considered?

Operating earnings before taxes Signup and view all the answers

What is the relationship between the cost of capital and the discount rate in a discounted cash flow model?

The cost of capital is used to estimate the discount rate Signup and view all the answers

What is free cash flow (FCF) in a discounted cash flow model?

The cash available for the company to repay creditors or pay dividends and interest to investors Signup and view all the answers

What is the primary purpose of estimating the Free Cash Flow to Equity (FCFE)?

To evaluate the feasibility of a project Signup and view all the answers

What is the effect of an increase in working capital on the calculation of Free Cash Flow to the Firm (FCFF)?

It decreases the FCFF Signup and view all the answers

What is the relationship between the cost of capital and the discount rate in a capital budgeting project?

The cost of capital is equal to the discount rate Signup and view all the answers

How does a decrease in a firm's debt affect the calculation of Free Cash Flow to Equity (FCFE)?

It increases the FCFE Signup and view all the answers

What is the primary difference between nominal and real cash flows?

Nominal cash flows are in current dollars, while real cash flows are in constant dollars Signup and view all the answers

What is the purpose of estimating the terminal growth rate in a capital budgeting project?

To forecast the firm's cash flows beyond the forecast period Signup and view all the answers

How does an increase in capital expenditures affect the calculation of Free Cash Flow to the Firm (FCFF)?

It decreases the FCFF Signup and view all the answers

What is the primary purpose of estimating the discount rate in a capital budgeting project?

To evaluate the feasibility of a project Signup and view all the answers

What is the primary consideration when selecting a discount rate for a cash flow?

The type of cash flow being discounted Signup and view all the answers

If the cash flows being discounted are nominal cash flows, what type of discount rate should be used?

Nominal discount rate Signup and view all the answers

What is the formula for estimating the cost of equity (Ke)?

Ke = Rf + β x (Rm-Rf) Signup and view all the answers

What should be used to discount cash flows to the firm?

Cost of capital Signup and view all the answers

What is the primary difference between the cost of equity and the cost of debt?

The cost of debt reflects default risk Signup and view all the answers

When estimating the cost of equity for a company with international operations, what should be considered?

All of the above Signup and view all the answers

What is the purpose of estimating the cost of equity?

To compensate equity investors for the risk they undertake Signup and view all the answers

What is the relationship between the cost of equity and the beta of the company?

The cost of equity is directly proportional to the beta Signup and view all the answers

In a two-stage DCF model, the terminal growth rate is used to estimate the present value of cash flows beyond the forecast period. Which of the following statements about the terminal growth rate is true?

It should be equal to the long-term average growth rate of the economy Signup and view all the answers

When estimating cash flows for a DCF valuation, which of the following is an example of a nominal cash flow?

Cash flow in nominal terms, including the effects of inflation Signup and view all the answers

What is the primary purpose of estimating the cost of capital in a DCF valuation?

To determine the discount rate Signup and view all the answers

Which of the following methods is commonly used to estimate the cost of capital for a company?

Weighted Average Cost of Capital (WACC) Signup and view all the answers

When estimating the discount rate in a DCF valuation, which of the following factors should be considered?

The risk-free rate and the market risk premium Signup and view all the answers

Which of the following cash flows should be excluded when estimating cash flows for a DCF valuation?

Interest expenses Signup and view all the answers

In a DCF valuation, what is the purpose of estimating the present value of cash flows?

To determine the intrinsic value of a company's stock Signup and view all the answers

Which of the following is a common approach to forecasting cash flows in a DCF valuation?

Using a two-stage model Signup and view all the answers

Study Notes

Discounted Cash Flow (DCF) Models

DCF models estimate the value of a company based on the present value of its future cash flows.

Estimating Cash Flow

Free cash flow (FCF) represents the cash available for a company to repay creditors or pay dividends and interest to investors.
Estimate the current earnings of the firm:
- If looking at cash flows to equity, look at earnings after interest expenses - i.e. net income.
- If looking at cash flows to the firm, look at operating earnings after taxes.
Consider how much the firm invested to create future growth:
- If the investment is not expensed, it will be categorized as capital expenditures.

Estimating Growth Rate

Growth rate is a key input in DCF models.
Growth rate can be estimated based on historical data, industry trends, or management's guidance.

Estimating Cost of Capital

The cost of capital is the rate of return required by investors.
The cost of capital is a function of the riskiness of the company and the type of cash flows being discounted.
Cost of equity (Ke):
- Ke = Rf + β x (Rm-Rf)
- Ke = Rf + CRP + Beta (Mature ERP)
Cost of debt (Kd):
- The cost of debt is the rate at which the company can borrow at currently.

Valuation Process

Valuation is based on expected future performance, not past performance.
Valuation involves:
- Analysis of the economic environment.
- Analysis of the industry.
- Analysis of the financial history and prospects of the business.
- Forecasting the future operations of the business.
- Applying acceptable valuation methods.

DCF Formula

Stock Value = Σ (CFt / (1+r)^t)

Two-Stage DCF Valuation Model

Forecast period: typically 5-10 years.
Terminal year: the year after the forecast period.
Cash flows can be forecast for any number of years.
Discount rate: 1/(1+r)^t

Practice Questions

Practice 1:
- Expected dividend growth rate: 12% + 2% = 14%.
- Required rate of return: 14%.
- Growth rate: 4% pa.
Practice 2:
- Current dividend: $2.00.
- Required rate of return: 14%.
- Dividend growth pattern: 3% for 3 years, 2% afterwards.

Other Concepts

Net income: earnings after interest expenses and taxes.
Depreciation and amortization: non-cash expenses.
Capital expenditures: investments in the company.
Changes in working capital: changes in current assets and liabilities.
Free cash flow to equity (FCFE): cash available for distribution to equity investors.
Principal debt repayments: repayments of principal debt.
New debt issues: issuance of new debt.

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