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Found in: Page 442

Essentials Of Investments

Book edition 9th
Author(s) Zvi Bodie, Alex Kane, Alan Marcus, Alan J. Marcus
Pages 748 pages
ISBN 9780078034695

While valuing the equity of Rio National Corp. (from the previous problem), Katrina Shaar is considering the use of either free cash flow to the firm (FCFF) or free cash flow to equity (FCFE) in her valuation process.a. State two adjustments that Shaar should make to FCFF to obtain free cash flow to equity.b. Shaar decides to calculate Rio National’s FCFE for the year 2012, starting with net income. Determine for each of the five supplemental notes given in Table 13.7 whether an adjustment should be made to net income to calculate Rio National’s free cash flow to equity for the year 2012, and the dollar amount of any adjustment.c. Calculate Rio National’s free cash flow to equity for the year 2012.

a. Subtract investment in fixed capital and Add net borrowing

b. (i) negative $75 million (ii) positive$3 million (iii) negative $5 million (iv) no adjustment (v) no adjustment c. -$55

See the step by step solution

Step 1: Explanation on adjustments ‘a’

1. Subtract investment in fixed capital: Since the investing activities in long-term assets, particularly plant and equipment are not available to equity holders therefore it should be subtracted from CFO.

2. Add net borrowing: Since the amount of capital supplied to the firm by lenders therefore new borrowings, net of debt repayment, etc. should be added to CFO to obtain FCFE.

Step 2: Explanation on adjustment to net income and Calculation of free cash flow to equity ‘b’

Note 1: Adjustment: negative $75 million hence the cash flows should be subtracted from net income to obtain FCFE. Note 2: Adjustment: positive$3 million In calculating FCFE, only cash flow investments in fixed capital is be considered, therefore $7 million sale price of equipment should be added to net income. However, the gain over book value$4 million is already included in net income hence the $3 million net book value must be added to net income. Note 3: Adjustment: negative$5 million The unscheduled debt repayment cash flow should be subtracted from net income to determine FCFE.

Note 4: No adjustment Transactions between the firm and its shareholders do not affect FCFE hence no adjustment to net income is required for calculating FCFE.

Note 5: No adjustment Since the increased market value of the land did not generate any cash flow therefore, no adjustment to net income is required for calculating FCFE.

Step 3: Calculation of free cash flow to equity

Formulae of FCFE = NI + NCC – FCINV – WCINV + Net Borrowing

 Million $Explanation NI =$30.16 From Exhibit 18B (Non-cash charges) NCC = +$67.17$71.17 (depreciation and amortization from Exhibit 18B) – $4.00* (gain on sale from Note 2) (Investment in fixed capital ) FCINV = –$68.00 $75.00 (capital expenditures from Note 1) –$7.00* (cash on sale from Note 2) (Investment in working capital WCINV = –$24.00 –$3.00 (increase in accounts receivable from Exhibit 18A + –$20.00 (increase in inventory from Exhibit 18A) + –$1.00 (decrease in accounts payable from Exhibit 18A) Net Borrowing = +(–$5.00) –$5.00 (decrease in long-term debt from Exhibit 18A) FCFE = \$0.33