Question #118

Reading: Reading 21 Free Cash Flow Valuation

PDF File: Reading 21 Free Cash Flow Valuation.pdf

Page: 60

Status: Unattempted

Correct Answer: A

Part of Context Group: Q117-118
Shared Context
- Which of the following statements regarding forecasting FCFE using the components of free cash flow method and net borrowing is most accurate? 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.
Question
Which of the following statements regarding the effect a decrease in leverage has on a firm's free cash flow from equity (FCFE) is most accurate?
Answer Choices:
A. Current year FCFE decreases, but future FCFE will be increased
B. FCFE is unaffected by changes in leverage
C. Current year FCFE increases, but future FCFE will be reduced
Explanation
Changes in leverage do have a small effect on FCFE. A decrease in leverage will cause the current year FCFE to decrease through the repayment of debt. Future FCFE will be increased because interest expense will be lower.
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