Question 1

Which of the following statements is CORRECT?
A) two firms with the same expected free cash flows and growth rates must also have the same value of operations.
B) it is appropriate to use the constant growth model to estimate a stock's value even if its growth rate is never expected to become constant.
C) if a company has a weighted average cost of capital wacc = 12%, and if its free cash flows are expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%.
D) the value of operations is the present value of all expected future free cash flows, discounted at the free cash flow growth rate.
E) the constant growth model takes into consideration the capital gains investors expect to earn on a stock.

Accepted Answer

Statement e is true, because the expected growth rate is also the expected capital gains yield. All the other statements are false.

Question 2

According to the basic FCF stock valuation model, the value an investor should assign to a share of stock is dependent on the length of time he or she plans to hold the stock.

Accepted Answer

The basic Free Cash Flow (FCF) stock valuation model determines the value of a stock based on the present value of the company's expected future cash flows, independent of the investor's holding period.

Question 3

Which of the following statements is NOT CORRECT?
A) the free cash flow valuation model discounts free cash flows by the required return on equity.
B) the free cash flow valuation model can be used to find the value of a division.
C) an important step in applying the free cash flow valuation model is forecasting the firm's pro forma financial statements.
D) free cash flows are assumed to grow at a constant rate beyond a specified date in order to find the horizon, or terminal, value.
E) the free cash flow valuation model can be used both for companies that pay dividends and those that do not pay dividends.

Accepted Answer

The free cash flow valuation model discounts free cash flows by the cost of capital, which is a combination of the required return on equity and the cost of debt.

Question 4

The free cash flow valuation model cannot be used unless a company doesn't pay dividends.

Accepted Answer

The free cash flow valuation model can be used for companies that pay dividends. In fact, the model takes into account the dividends paid to shareholders as a use of cash. Therefore, the model is commonly used to value dividend-paying stocks.

Question 5

Young & Liu Inc.'s free cash flow during the just-ended year (t = 0) was $100 million, and FCF is expected to grow at a constant rate of 5% in the future. If the weighted average cost of capital is 15%, what is the firm's value of operations, in millions?
A) $948
B) $998
C) $1,050
D) $1,103
E) $1,158

Accepted Answer

$\begin{array}{lr}
\mathrm{FCF}_{0} & \$ 100 \
\mathrm{~g} & 5 \% \
\mathrm{WACC} & 15 \%
\end{array}$ 
 
$
\begin{array}{l}
\text {Value Ops}\
&=\mathrm{FCF}_{1} /(\mathrm{WACC}-\mathrm{g})=\mathrm{FCF}_{0}(1+\mathrm{g}) /(\mathrm{WACC}-\mathrm{g}) \
&=\$ 100(1+0.05) /(0.15-0.05)=\$ 105 / 0.1=\$ 1,050
\end{array}
$

Question 6

Companies can issue different classes of common stock. Which of the following statements concerning stock classes is CORRECT?
A) all common stocks, regardless of class, must have the same voting rights.
B) all firms have several classes of common stock.
C) all common stock, regardless of class, must pay the same dividend.
D) some class or classes of common stock are entitled to more votes per share than other classes.
E) all common stocks fall into one of three classes: a, b, and c.

Accepted Answer

Companies can issue different classes of common stock and some class or classes of common stock are entitled to more votes per share than other classes. This is known as a dual-class structure and it is commonly used by tech firms, where the founders or top executives hold a class of shares with greater voting power, allowing them to maintain control over the company even if they own a relatively small portion of the equity. The other statements are incorrect: A) different classes of common stock can have different voting rights, B) not all firms have several classes of common stock, C) different classes of common stock can have different dividend rates, and E) there is no universal classification system for common stock.

Question 7

Justus Motor Co.has a WACC of 11.50%, and its value of operations is $25.00 million. Justus's free cash flow is expected to grow at a constant rate of 7.00%. What was the last free cash flow, FCF0 in millions?
A) $0.95
B) $1.05
C) $1.16
D) $1.27
E) $1.40

Accepted Answer

$\begin{array}{lr}
\text { Value of operations } & \$ 25.00 \
\text { Required return } & 11.50 \% \
\text { Growth rate } & 7.00 \% \
\mathrm{~V}_{\text {ops }}=\mathrm{FCF}_{1} /(\mathrm{WACC}-\mathrm{g}), \text { so } \mathrm{FCF}_{1}= & \$ 1.1250 \
\mathrm{~V}_{\text {ops }}(\mathrm{WACC}-\mathrm{g})= & \
\text { Last } \mathrm{FCF}=\mathrm{FCF}_{0}=\mathrm{FCF}_{1} /(1+\mathrm{g}) & \$ 1.05
\end{array}$

Question 8

A proxy is a document giving one party the authority to act for another party, including the power to vote shares of common stock. Proxies can be important tools relating to control of firms.

Accepted Answer

This statement accurately describes what a proxy is and how it can be used in regards to the control of firms.

Question 9

Projected free cash flows should be discounted at the firm's weighted average cost of capital to find the value of its operations.

Accepted Answer

This is the correct method for valuing a firm's operations using discounted free cash flows. The weighted average cost of capital represents the minimum return that investors expect to earn in order to compensate for the level of risk associated with investing in the firm. Discounting the projected free cash flows at this rate accounts for both the time value of money and the riskiness of the firm's cash flows.

Question 10

If a firm's stockholders are given the preemptive right, this means that stockholders have the right to call for a meeting to vote to replace the management. Without the preemptive right, dissident stockholders would have to seek a change in management through a proxy fight.

Accepted Answer

The statement is incorrect. The preemptive right refers to the right of stockholders to maintain their proportional ownership in a company by having the first opportunity to buy newly issued shares of stock before they are offered to the public. It does not relate to the ability to replace management.

Question 11

If a company's free cash flows are expected to grow at a constant rate of 5% a year, which of the following statements is CORRECT?The stock is in equilibrium.
A) the company's stock's dividend yield is 5%.
B) the value of operations is expected to decline in the future.
C) the company's wacc must be equal to or less than 5%.
D) the company's value of operations one year from now is expected to be 5% above the current price.
E) the expected return on the company's stock is 5% a year.

Accepted Answer

Statement d is true, because the value of operations is expected to grow at the free cash flow growth rate.

Question 12

A company's free cash flow was just FCF0 = $1.50 million. The weighted average cost of capital is WACC = 10.1%, and the constant growth rate is g = 4.0%. What is the current value of operations?
A) $23.11 million
B) $23.70 million
C) $24.31 million
D) $24.93 million
E) $25.57 million

Accepted Answer

$\begin{array}{lr}
\mathrm{FCF}_{0} & \$ 1.50 \
\mathrm{WACC}_{\mathrm{g}} & 10.1 \% \
\mathrm{FCF}_{1}=\mathrm{FCF}_{0}(1+\mathrm{g})= & 4.0 \% \
\mathrm{~V}_{\text {ops }}=\mathrm{FCF}_{1} /\left(\mathrm{r}_{\mathrm{S}}-\mathrm{g}\right) & \$ 1.56
\end{array}$

Question 13

The preemptive right is important to shareholders because it
A) will result in higher dividends per share.
B) is included in every corporate charter.
C) protects the current shareholders against a dilution of their ownership interests.
D) protects bondholders, and thus enables the firm to issue debt with a relatively low interest rate.
E) allows managers to buy additional shares below the current market price.

Accepted Answer

The preemptive right allows current shareholders to maintain their ownership percentage in the company by giving them the first opportunity to purchase new shares before they are offered to the public. This protects shareholders from dilution of their ownership interests.

Question 14

Lance Inc.'s free cash flow was just $1.00 million. If the expected long-run growth rate for this company is 5.4%, if the weighted average cost of capital is 11.4%, Lance has $4 million in short-term investments and $3 million in debt, and 1 million shares outstanding, what is the intrinsic stock price?
A) $17.28
B) $17.70
C) $18.13
D) $18.57
E) $19.01

Accepted Answer

$\begin{array}{lr}
\text { Last } F C F\left(F_{0}\right) & \$ 1.00 \text { million } \
\text { Long-run growth rate } & 5.4 \% \
\text { Required return } & 11.4 \% \
F^{*} F_{1}=F_{0}(1+g)= & \text { million } \
& \$ 17.57 \
\left.\mathrm{~V}_{\text {ops }}=\mathrm{FCF}_{1} / \text { (WACC }-\mathrm{g}\right) & \text { million } \
\text { Short-term investments }= & \$ 4 \text { million } \
\text { Debt }= & \$ 3 \text { million } \
\text { Shares outstanding }= & 1 \text { million }
\end{array}$ 
Intrinsic value of equity = Value of operations + short-term investments - all debt - preferred stock = 17.57 + 4 - 3 - 0 = $18.57 million. Intrinsic stock price = intrinsic value of equity/number of shares = 18.57/1 = $18.57.

Question 15

Which of the following statements is CORRECT?
A) the preemptive right gives stockholders the right to approve or disapprove of a merger between their company and some other company.
B) the preemptive right is a provision in the corporate charter that gives common stockholders the right to purchase (on a pro rata basis) new issues of the firm's common stock.
C) the free cash flow valuation model, vops =fcf1/(wacc σ g), cannot be used for firms that have negative growth rates.
D) the free cash flow valuation model, vops = fcf1/(wacc σ g), can be used only for firms whose growth rates exceed their wacc.
E) if a company has two classes of common stock, class a and class b, the stocks may pay different dividends, but under all state charters the two classes must have the same voting rights.

Accepted Answer

Statement a is simply false. Statement b is true. Statements c and d are false, because the constant growth model can be used anytime as long as the constant growth rate is less than the required return (even if the growth rate is negative). Statement e is falseσa number of companies have different classes of stock with different voting rights.

Question 16

Founders' shares are a type of classified stock where the shares are owned by the firm's founders, and they generally have more votes per share than the other classes of common stock.

Accepted Answer

Founders' shares are indeed a type of classified stock that grants more voting power to the founders compared to other classes of common stock.

Question 17

The projected cash flow for the next year for Minesuah Inc. is $100,000, and FCF is expected to grow at a constant rate of 6%. If the company's weighted average cost of capital is 11%, what is the value of its operations?
A) $1,714,750
B) $1,805,000
C) $1,900,000
D) $2,000,000
E) $2,100,000

Accepted Answer

$\begin{array}{lr}
\mathrm{FCF}_{1}: & \$ 100,000 \
\mathrm{~g} & 6 \% \
\mathrm{WACC} & 11 \%
\end{array}$ 
 
$
\begin{array}{l}
\text {Value Ops}\
&=\mathrm{FCF}_{1} /(\mathrm{WACC}-\mathrm{g})=\mathrm{FCF}_{0}(1+\mathrm{g}) /(\mathrm{WACC}-\mathrm{g}) \
&=\$ 100,000 /(0.11-0.06)=\$ 100,000 / 0.05=\$ 2,000,000
\end{array}
$

Question 18

The preemptive right gives current stockholders the right to purchase, on a pro rata basis, any new shares issued by the firm. This right helps protect current stockholders against both dilution of control and dilution of value.

Accepted Answer

The statement accurately describes the preemptive right. By allowing current stockholders to purchase new shares in proportion to their existing ownership, the preemptive right helps prevent their ownership percentage and the value of their investment from being diluted by the issuance of new shares to others.

Question 19

Classified stock differentiates various classes of common stock, and using it is one way companies can meet special needs such as when owners of a start-up firm need additional equity capital but don't want to relinquish voting control.

Accepted Answer

This statement is true. Classified stock allows for different classes of common stock, which can be used to meet special needs such as maintaining voting control while raising additional equity capital.

Question 20

The cash flows associated with common stock are more difficult to estimate than those related to bonds because stock has a residual claim against the company versus a contractual obligation for a bond.

Accepted Answer

This statement is true. Common stockholders are residual claimants, which means they have a right to the remaining assets after all other stakeholders (such as bondholders) have been satisfied. This makes it more difficult to estimate the cash flows associated with common stock compared to bonds, which have a contractual obligation for repayment of principal and interest.

Quiz 8: Basic Stock Valuation

Which of the following statements is CORRECT?

According to the basic FCF stock valuation model, the value an investor should assign to a share of stock is dependent on the length of time he or she plans to hold the stock.

Which of the following statements is NOT CORRECT?

The free cash flow valuation model cannot be used unless a company doesn't pay dividends.

Young & Liu Inc.'s free cash flow during the just-ended year (t = 0) was $100 million, and FCF is expected to grow at a constant rate of 5% in the future. If the weighted average cost of capital is 15%, what is the firm's value of operations, in millions?

Companies can issue different classes of common stock. Which of the following statements concerning stock classes is CORRECT?

Justus Motor Co.has a WACC of 11.50%, and its value of operations is $25.00 million. Justus's free cash flow is expected to grow at a constant rate of 7.00%. What was the last free cash flow, FCF0 in millions?

A proxy is a document giving one party the authority to act for another party, including the power to vote shares of common stock. Proxies can be important tools relating to control of firms.

Projected free cash flows should be discounted at the firm's weighted average cost of capital to find the value of its operations.

If a firm's stockholders are given the preemptive right, this means that stockholders have the right to call for a meeting to vote to replace the management. Without the preemptive right, dissident stockholders would have to seek a change in management through a proxy fight.

If a company's free cash flows are expected to grow at a constant rate of 5% a year, which of the following statements is CORRECT?The stock is in equilibrium.

A company's free cash flow was just FCF0 = $1.50 million. The weighted average cost of capital is WACC = 10.1%, and the constant growth rate is g = 4.0%. What is the current value of operations?

The preemptive right is important to shareholders because it

Which of the following statements is CORRECT?

Founders' shares are a type of classified stock where the shares are owned by the firm's founders, and they generally have more votes per share than the other classes of common stock.

The projected cash flow for the next year for Minesuah Inc. is $100,000, and FCF is expected to grow at a constant rate of 6%. If the company's weighted average cost of capital is 11%, what is the value of its operations?

The preemptive right gives current stockholders the right to purchase, on a pro rata basis, any new shares issued by the firm. This right helps protect current stockholders against both dilution of control and dilution of value.

Classified stock differentiates various classes of common stock, and using it is one way companies can meet special needs such as when owners of a start-up firm need additional equity capital but don't want to relinquish voting control.

The cash flows associated with common stock are more difficult to estimate than those related to bonds because stock has a residual claim against the company versus a contractual obligation for a bond.