Question #98
Reading: Reading 21 Free Cash Flow Valuation
PDF File: Reading 21 Free Cash Flow Valuation.pdf
Page: 46
Status: Unattempted
Correct Answer: B
Question
Which of the following types of companies is the two-stage free cash flow to equity (FCFE) model best suited for? Companies:
Answer Choices:
A. growing at a rate similar to or less than the nominal growth rate of the economy
B. with patents or firms in an industry with significant barriers to entry
C. in high growth industries that will face increasing competitive pressures over time, leading to a gradual decline in growth to a stable level. Harrisburg Tire Company (HTC) forecasts the following for 2013: Earnings (net income) = $600M. Dividends = $120M. Interest expense = $400M. Tax rate = 40.0%. Depreciation = $500M. Capital spending = $800M. Total assets = $10B (book value and market value). Debt = $4B (book value and market value). Equity = $6B (book value and market value). Target debt to asset ratio = 0.40. Shares outstanding = 2.0 billion The firm's working capital needs are negligible, and HTC plans to continue to operate with the current capital structure. The tire industry demand is highly dependent on demand for new automobiles. Individual companies in the industry don't have much influence on the design of automobiles and have very little ability to affect their business environment. The demand for new automobiles is highly cyclical but demand forecast errors tend to be low
Explanation
The two-stage model is best suited to analyzing firms in a high growth phase that will
maintain that growth for a specific period, such as firms with patents or firms in an
industry with significant barriers to entry. Companies growing at a rate similar to or less
than the nominal growth rate of the economy are best suited for the single-stage FCFE
Model. Companies in high growth industries correspond to the three-Stage FCFE Model.
(Module 21.5, LOS 21.j)
Harrisburg Tire Company (HTC) forecasts the following for 2013:
Earnings (net income) = $600M.
Dividends = $120M.
Interest expense = $400M.
Tax rate = 40.0%.
Depreciation = $500M.
Capital spending = $800M.
Total assets = $10B (book value and market value).
Debt = $4B (book value and market value).
Equity = $6B (book value and market value).
Target debt to asset ratio = 0.40.
Shares outstanding = 2.0 billion
The firm's working capital needs are negligible, and HTC plans to continue to operate with the current capital
structure. The tire industry demand is highly dependent on demand for new automobiles. Individual companies in the
industry don't have much influence on the design of automobiles and have very little ability to affect their business
environment. The demand for new automobiles is highly cyclical but demand forecast errors tend to be low.