Question #116 - Reading 21 Free Cash Flow Valuation

Reading: Reading 21 Free Cash Flow Valuation

PDF File: Reading 21 Free Cash Flow Valuation.pdf

Page: 59

Status: Unattempted

Correct Answer: B

Shared Context

- Regarding statements 1 and 2, are Ballmer's interpretations of free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) CORRECT? A) No, only one interpretation is correct. B) Yes, both interpretations are correct. C) No, neither interpretation is correct.

Question

Which of the following statements regarding forecasting FCFE using the components of free cash flow method and net borrowing is most accurate?

Answer Choices:

A. Net income already accounts for interest expense; therefore, net borrowing is not needed

B. Investment in fixed capital and net borrowing are assumed to offset each other

C. The target debt-to-asset ratio accounts for the financing of new investment in fixed capital and working capital

Explanation

When forecasting FCFE, it is common to assume that a firm will maintain a target debt-to- asset ratio for new investments in fixed capital and working capital. Based on this assumption, the formula for forecasting FCFE is: FCFE = NI − [(1 − DR) × (FCInv − Dep)] − [(1 − DR) × WCInv] By multiplying the fixed capital and working capital investments by one minus the target debt-to-asset ratio, you are left with the investment amount less the amount financed by debt, which is the net borrowing amount. Therefore, this formula accounts for net borrowing through the target debt-to-asset ratio.

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