Question

45. Your firm buys another firm for vertically integration. The initial FCF’s are 1 million per year starting the year and expected to grow at 3% per year. To your surprise, the actual FCF’s turn out to be 1.2 million per year starting this year with the same growth rate. How much did you underpay from your original analysis assuming the WACC is 9%.

1. 3.6 million
2. 3.4 million
3. 2.8 million
4. 3.3 million

46. Answer the following true/false statements:

a. T/F For question 45, If they used the same amount of debt to buy the firm, the debt to ebitda ratio should decrease when the higher FCF’s were realized

b. T/F As the risk free rate goes up values of stocks and bonds should go down as the required returns will increase (assume dividends and FCF’s and growth remain constant)

c. T/F   If I feel the future cash flows of stock and bonds is more secure. The value of each will decrease

d. T/F Preferred stock gets paid out in a chapter 11 after stocks

Answer 1

Answer 45:

Correct answer is:

b. 3.4 million

Explanation:

Value of firm = FCF next year / (WACC - Constant growth rate)

Assuming current year FCF = $1 million:

Value of firm = 1 * (1 + 3%) / (9% - 3%) = $17.17 million

Actual current year FCF = $1.2 million:

Value of firm = 1.2 * (1 + 3%) / (9% - 3%) = $20.60 million

Amount underpaid = 20.60 - 17.17 = 3.4 million

As such option b is correct and other options a, c and d are incorrect.

Answer 46:

a. True

As FCF are higher EBITDA should be higher. Debt remaining same debt to EBITDA ratio should decrease higher FCF’s were realized.

b. True

Required return = Risk free return + Beta * Market premium.

Hence if risk free rate goes up, required return will increase and values of stocks and bonds should go down (assuming dividends and FCF’s and growth remain constant)

c. False.

If I feel the future cash flows of stock and bonds is more secure. The value of each will increase.

d. False.

Preferred stock gets paid out in a chapter 11 before common stocks