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
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.
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.
Formulae of FCFE = NI + NCC – FCINV – WCINV + Net Borrowing
From Exhibit 18B
(Non-cash charges) NCC =
$71.17 (depreciation and amortization from Exhibit 18B) – $4.00* (gain on sale from Note 2)
(Investment in fixed capital ) FCINV =
$75.00 (capital expenditures from Note 1) – $7.00* (cash on sale from Note 2)
(Investment in working capital WCINV =
–$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 (decrease in long-term debt from Exhibit 18A) FCFE = $0.33
Use the following case in answering Problems 29 – 32:
Mary Smith, a Level II CFA candidate, was recently hired for an analyst position at the Bank of Ireland. Her first assignment is to examine the competitive strategies employed by various French wineries.
Smith’s report identifies four wineries that are the major players in the French wine industry. The key characteristics of each are cited in Table 12.6. In the body of Smith’s report, she includes a discussion of the competitive structure of the French wine industry. She notes that over the past five years, the French wine industry has not responded to changing consumer tastes. Profit margins have declined steadily, and the number of firms representing the industry has decreased from 10 to 4. It appears that participants in the French wine industry must consolidate in order to survive.
Smith’s report notes that French consumers have strong bargaining power over the industry.
She supports this conclusion with five key points, which she labels “Bargaining Power of Buyers”:
After completing the first draft of her report, Smith takes it to her boss, RonVanDriesen, to review. VanDriesen tells her that he is a wine connoisseur himself and often makes purchases from the South Winery. Smith tells VanDriesen, “In my report, I have classified the South Winery as a stuck-in-the-middle firm. It tries to be a cost leader by selling its wine at a price that is slightly below the other firms, but it also tries to differentiate itself from its competitors by producing wine in bottles with curved necks, which increases its cost structure. The end result is that the South Winery’s profit margin gets squeezed from both sides.” VanDriesen replies, “I have met members of the management team from the South Winery at a couple of the wine conventions I have attended. I believe that the South Winery could succeed at following
both cost leadership and a differentiation strategy if its operations were separated into distinct operating units, with each unit pursuing a different competitive strategy.” Smith makes a note to do more research on generic competitive strategies to verify VanDriesen’s assertions before publishing the final draft of her report.
Smith notes in her report that the West Winery might differentiate its wine product on attributes that buyers perceive to be important. Which of the following attributes would be the most likely area of focus for the West Winery to create a differentiated product?
a. The method of delivery for the product
b. The price of the product
c. A focus on customers aged 30 to 45
The MoMi Corporation’s cash flow from operations before interest and taxes was $2 million in the year just ended, and it expects that this will grow by 5% per year forever.
To make this happen, the firm will have to invest an amount equal to 20% of pretax cash flow each year. The tax rate is 35%. Depreciation was $200,000 in the year just ended and is expected to grow at the same rate as the operating cash flow. The appropriate market capitalization rate for the unleveraged cash flow is 12% per year, and the firm currently has debt of $4 million outstanding. Use the free cash flow approach to value the firm’s equity.
The risk-free rate of return is 8%, the expected rate of return on the market portfolio is 15%, and the stock of Xyrong Corporation has a beta coefficient of 1.2. Xyrong pays out 40% of its earnings in dividends, and the latest earnings announced were $10 per share.
Dividends were just paid and are expected to be paid annually. You expect that Xyrong will earn an ROE of 20% per year on all reinvested earnings forever.
a. What is the intrinsic value of a share of Xyrong stock?
b. If the market price of a share is currently $100, and you expect the market price to be equal to the intrinsic value one year from now, what is your expected one-year holding-period return on Xyrong stock?
Helen Morgan, CFA, has been asked to use the DDM to determine the value of Sundanci, Inc. Morgan anticipates that Sundanci’s earnings and dividends will grow at 32% for two years and 13% thereafter.
Calculate the current value of a share of Sundanci stock by using a two-stage dividend discount model and the data from Tables 13.1 1 and 13.12 .
Use the following case in answering Problems 26 – 28:
Institutional Advisors for All Inc., or IAAI, is a consulting firm that primarily advises all types of institutions such as foundations, endowments, pension plans, and insurance companies. IAAI also provides advice to a select group of individual investors with large portfolios. One of the claims the firm makes in its advertising is that IAAI devotes considerable resources to forecasting and determining long-term trends; then it uses commonly accepted investment models to determine how these trends should affect the performance of various investments. The members of the research department
of IAAI recently reached some conclusions concerning some important macroeconomic trends. For instance, they have seen an upward trend in job creation and consumer confidence and predict that this should continue for the next few years. Other domestic leading indicators that the research department at IAAI wishes to consider are industrial production, average weekly hours in manufacturing, S&P 500 stock prices, M2 money supply, and the index of consumer expectations.
In light of the predictions for job creation and consumer confidence, the investment advisers at IAAI want to make recommendations for their clients. They use established theories that relate job creation and consumer confidence to inflation and interest rates and then incorporate the forecast movements in inflation and interest rates into established models for explaining asset prices. Their primary concern is to forecast how the trends in job creation and consumer confidence should affect bond prices and how those trends should affect stock prices.
The members of the research department at IAAI also note that stocks have been trending up in the past year, and this information is factored into the forecasts of the overall economy than they deliver. The researchers consider an upward-trending stock market a positive economic indicator in itself; however, they disagree as to the reason this should be the case.
The researchers at IAAI have forecast positive trends for both job creation and consumer confidence. Which, if either, of these trends, should have a positive effect on stock prices?
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