Question 1

A firm expects growth next year to be 10%. Its sustainable growth rate is 12%. Which of the following is true?

Accepted Answer

The firm's expected growth is less than its sustainable growth rate, indicating it can finance its growth internally without needing additional external capital. This may result in excess cash.

Question 2

Compute the value of a firm with free cash flows of $4,000, $4,500, and $5,000 over the next three years, a terminal firm value of $60,000 after three years, and the unlevered cost of capital is 10%. Assume that the interest rate tax shield is zero.

Accepted Answer

A) Compute the present value of the free cash flows and the terminal value.
Using CF keys of a financial calculator, CF1 = 4,000, CF2 = 4,500, CF3 = 5,000 + 60,000;
PV at interest rate of 10 = $56,191

Question 3

Compute the value of a firm with free cash flows of $1,000, $2,500, and $3,000 over the next three years, a terminal firm value of $40,000 after three years, and the unlevered cost of capital is 15%. Assume that the interest rate tax shield is zero.

Accepted Answer

C) Compute the present value of the free cash flows and the terminal value.
Using CF keys of a financial calculator, CF1 = 1,000, CF2 = 2,500, CF3 = 3,000 + 40,000;
PV at interest rate of 15 = $31,033

Question 4

Total working capital rather than changes in working capital has implications for cash flows.

Accepted Answer

Changes in working capital are directly related to cash flows, as they represent the difference between current assets and current liabilities over a period. This change affects how much cash is available for the company's operations and investments, not the total working capital at a single point in time.

Question 5

Given the following data for a given period, compute the free cash flow to the firm: Net Income = $12,000
After-tax Interest Expense = $2,000
Depreciation = $1,000
Increase in NWC = $2,000
Capital Expenditures = $1,000

Accepted Answer

C) Free cash flow = Net income + After-tax interest expense + Depreciation - Change in NWC - Capital expenditures
Free cash flow = 12,000 + 2,000 + 1,000 - 2,000 - 1,000 = $12,000

Question 6

Pledrea Inc. has EBITDA at the forecast horizon of $13,000. Its EBITDA multiple is 10. What is the terminal value of the firm at the forecast horizon?

Accepted Answer

D) Terminal value = EBITDA at horizon × EBITDA multiple
Terminal value = $13,000 × 10 = $130,000

Question 7

Given the following data for a given period, compute the free cash flow to the firm: Net Income = $5,000
After-tax Interest Expense = $500
Depreciation = $500
Increase in NWC = $1,000
Capital Expenditures = $2,000

Accepted Answer

A) Free cash flow = Net income + After-tax interest expense + Depreciation - Change in NWC - Capital expenditures
Free cash flow = 5,000 + 500 + 500 - 1,000 - 2,000 = $3,000

Question 8

Given the following data for a given period, compute the free cash flow to the firm: Net Income = $10,000
After-tax Interest Expense = $1,000
Depreciation = $1,000
Increase in NWC = $1,000
Capital Expenditures = $2,000

Accepted Answer

A) Free cash flow = Net income + After-tax interest expense + Depreciation - Change in NWC - Capital expenditures
Free cash flow = 10,000 + 1,000 + 1,000 - 1,000 - 2,000 = $9,000

Question 9

A firm expects growth next year to be 12%. Its sustainable growth rate is 10%. Which of the following is true?

Accepted Answer

The sustainable growth rate is the maximum rate at which a firm can grow without having to increase its debt-to-equity ratio. If a firm expects growth next year to be higher than its sustainable growth rate, it will need additional financing to support that growth.

Option A is incorrect because raising additional debt would increase the debt-to-equity ratio, which is not desirable if the firm wants to maintain a stable capital structure.

Option C is also incorrect because raising capital through a stock issue would dilute the ownership of existing shareholders, which may not be necessary if the firm can reduce dividend payments to retain earnings.

Option D is incorrect because if the firm has excess cash, it can use it to pay down debt or repurchase equity, but it may not have sufficient cash to do so if it needs financing for growth.

Therefore, the best choice is B, which suggests that the firm may be able to keep its debt-to-equity ratio the same by reducing dividends (assuming they are projected to be high enough). This would allow the firm to retain earnings and reinvest them in the business to support its growth.

Question 10

For valuing a planned expansion, in addition to forecasting cash flows we need to estimate the firm's continuation value.

Accepted Answer

Estimating the continuation value is important in valuing a planned expansion because it takes into account the long-term value of the firm beyond the forecasted cash flows, which is essential to determine if the expansion will generate sufficient returns to justify the investment.

Question 11

What is the free cash flow to equity holders for a firm with free cash flow of $7000, after-tax interest expense of $1,000, and an increase in debt of $3,000?

Accepted Answer

D) Free cash flow to equity = Free cash flow - After-tax interest expense + Increase in debt
Free cash flow to equity= $7,000 - $1,000 + $3,000 = $9,000

Question 12

Compute the after-tax interest expense for a firm with Interest on Excess Cash = $2,000, Interest on Debt = $7,000, and a tax rate of 30%.

Accepted Answer

D) After-tax interest expense = (1 - tax rate) × (Interest on Debt - Interest on Excess Cash)
After-tax interest expense = (1 - 0.3) × (7,000 - 2,000) = $3,500

Question 13

A firm has $80 million in equity and $40 million of debt, it pays dividends of 20% of net income, and has a net income of $10 million. What is the firm's sustainable growth rate?

Accepted Answer

D) Sustainable growth rate = (net income / beginning equity) × (1 - payout ratio)
Sustainable growth rate = ($10 million / $80 million) × (100% - 20%) = 10%

Question 14

Pledrea Inc. has EBITDA at the forecast horizon of $10,000. Its EBITDA multiple is 11. What is the terminal value of the firm at the forecast horizon?

Accepted Answer

B) Terminal value = EBITDA at horizon × EBITDA multiple
Terminal value = $10,000 × 11 = $110,000

Question 15

What is the free cash flow to equity holders for a firm with free cash flow of $9,000, after-tax interest expense of $3,000, and an increase in debt of $1,000?

Accepted Answer

B) Free cash flow to equity = Free cash flow - After-tax interest expense + Increase in debt
Free cash flow to equity = $9,000 - $3,000 + $1,000 = $7,000

Question 16

Pledrea Inc. has EBITDA at the forecast horizon of $10,000. Its EBITDA multiple is 12. What is the terminal value of the firm at the forecast horizon?

Accepted Answer

C) Terminal value = EBITDA at horizon × EBITDA multiple
Terminal value = $10,000 × 12 = $120,000

Question 17

Compute the after-tax interest expense for a firm with Interest on Excess Cash = $1,000, Interest on Debt = $5,000, and a tax rate of 30%.

Accepted Answer

B) After-tax interest expense = (1 - tax rate) × (Interest on Debt - Interest on Excess Cash)
After-tax interest expense = (1 - 0.3) × (5,000 -1,000) = $2,800

Question 18

What is the free cash flow to equity holders for a firm with free cash flow of $11,000, after-tax interest expense of $2,000, and an increase in debt of $2,000?

Accepted Answer

D) Free cash flow to equity = Free cash flow - After-tax interest expense + Increase in debt
Free cash flow to equity= $11,000 - $2,000 + $2,000 = $11,000

Question 19

The estimate of a firm's value at the end of the forecast horizon using a valuation multiple is also called its ________.

Accepted Answer

The estimate of a firm's value at the end of the forecast horizon using a valuation multiple is called its terminal value. This represents the assumed value of the firm at the end of the forecast period and is often calculated using a multiple of the firm's earnings or cash flow. A and B are not correct because they are not terms used in this context.

Question 20

Compute the after-tax interest expense for a firm with Interest on Excess Cash = $5,000, Interest on Debt = $8,000, and a tax rate of 30%.

Accepted Answer

A) After-tax interest expense = (1 - tax rate) × (Interest on Debt - Interest on Excess Cash)
After-tax interest expense = (1 - 0.3) × (8,000 - 5,000) = $2,100

Quiz 18: Financial Modeling and Pro Forma Analysis