## Challenge Problems

1 6. Suppose an analyst estimates equity value by discounting free cash flow to equity (FCFE) at the weighted average cost of capital (WACC) in the FCFE model and esrimares firm and equity value by discounting free cash flow to the firm (FCFF) at the required return on equity in the FCFF model. The analyst would most likely-.

A. overestimate equity value with the FCFE model and underestimate firm value and equity value with the FCFF model.

B. underestimate equity value with the FCFE model and overestimate firm value and equity value with the FCFF model.

C. underestimate equity value with the FCFE model and underestimate firm value and equity value with the FCFF model.

Use the following information to answer Questions 17 through 19.

Meyer Henderson, CFA, is analyzing the Financials of Roth Department Stores. He intends to use a free cash flow to the firm (FCFF) model to value Roth's common stock. In rhe 2007 Financial statements and footnotes he has identified the following items:

• Item # 1: Roth reported depreciation and sofrware amortization of \$23 million in 2007.

• Item #2: The deferred tax liability increased by \$17 million in 2007.

• Item #3: Roth reported income of \$6 million in 2007 from the reversal of previous restructuring charges related to store closings in 2006.

• Item #4: Net income totaled \$173 million in 2007.

• Item #5: The net increase in noncash net working capital accounts was \$47 million in 2007.

• Item #6: Net capital spending totaled \$86 million in 2007.

• Item #7: Roth reported interest expense of \$ 19 million.

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Henderson estimated Roth's marginal tax rate to be 35%. He also expects Roth to be profitable for the foreseeable future, so he does not expect the deferred tax liability to reverse. As the base-year projection for his FCFF valuation, Henderson calculates FCFF for 2007 as:

FCFF2007 = \$173 + \$23 + \$6 + \$17 ♦ [\$19(1 - 0.35)] - \$86 - \$47 = \$98.35 million

17. In implementing the FCFF model to value Roth, did Henderson correctly treat Items tt\ and H2]

A. Both items treated correctly.

B. One correct, one incorrect.

C. Neither item treated correctly.

18. In implementing the FCFF model to value Roth, did Henderson correctly treat Items #3 and #4?

A. Both items treated correctly.

B. One correct, one incorrect.

C. Neither item treated correctly.

19. In implementing the FCFF model to value Roth, did Henderson correctly treat Items #5 and #7?

A. Both items treated correctly.

B. One correct, one incorrect.

C. Neither item treated correctly.

Use the following information to answer Questions 20 and 21.

At the end of 2007, Meyer Henderson, CFA, also prepared a 10-year forecast of free cash flow to equity (FCFE) and free cash flow to the firm (FCFF) from 2008 to 2017 for Trammel Medical Supplies. In early 2008 Trammel unexpectedly announced a new 15-year issue of senior debt. The proceeds are expected to be used to repurchase common stock in the open market during 2008.

20. As a result of the unexpected debt issue, Henderson should most likely.

A. increase his FCFE forecast for 2008 and decrease his FCFE forecast for 2009 through 2017.

B. decrease his FCFE forecast for 2008 and increase his FCFE forecast for 2009 through 2017.

C. increase his FCFE forecast for 2008 and not change his FCFE forecast for 2009 through 2017.

21. As a result of the unexpected debt issue, Henderson should most likely:

A. increase his FCFF forecasr for 2008 and decrease his FCFF forecast for 2009 rhrough 2017.

B. decrease his FCFF forecast for 2008 and increase his FCFF forecast for 2009 through 2017.

C. not change his FCFF forecasr for 2008 and also not change his FCFF forecast for 2009 through 2017.

22. Given the following information, calculate free cash flow to equity:

• Beginning gross Fixed assets = \$90; ending gross fixed assets = \$136.

• Beginning accumulated depreciation = \$30; ending accumulated depreciation = \$40.

In addition, a piece of equipment with an original book value of \$19 was sold for \$ 10. The equipment had a book value at the time of rhe sale of \$2. The gain was classified as unusual. Free cash flow to equity is closest to:

23. Chamber Group is analyzing the potential takeover of Outmenu Inc. Chamber has gathered the following data on Outmenu. All figures are in millions of dollars. 