Question #65
Reading: Reading 21 Free Cash Flow Valuation
PDF File: Reading 21 Free Cash Flow Valuation.pdf
Page: 32
Status: Unattempted
Question
Mark Washington, CFA, uses a two-stage free cash flow to equity (FCFE) discount model to value Texas Van Lines. His analysis yields an extremely low value, which he believes is incorrect. Which of the following is least likely to be a cause of this suspect valuation estimate?
Answer Choices:
A. The forecast of working capital as a percentage of revenues in the stable growth period is not large enough to maintain the long-term sustainable growth rate
B. Earnings are temporarily depressed because of a one-time extraordinary accounting charge in the most recent fiscal year
C. The cost of equity estimate in the stable growth period is too high for a stable firm
Explanation
The larger the estimate of working capital as a percentage of revenues, the larger the
investment in net working capital, and the lower the FCFE in the stable period. A low
stable-period FCFE estimate will result in a low estimate of value today. The solution is to
use a working capital ratio closer to the long-run industry average.
If the cost of equity estimate in the stable growth period is too high, the terminal value will
be too low. Because the terminal value typically makes up a large portion of the current
value, this will cause the current value estimate to be too low. The solution is to use a cost
of equity estimate based on a beta of one.
If earnings are temporarily depressed, all the FCFE estimates will be low, and the current
value estimate will be low. The solution is to use an estimate of long-run normalized
earnings.