# Study Session 11: Equity Investments: Free Cash Flow and Other Valuation Models

## FCFF vs FCFE

Hi all,

I am new here and hope you can help clear some confusion that relates to my work. I am very confused with the way FCFF and FCFE are calculated. Two specific questions:

1. CAPEX: When I look at the BS, I can see the PPE and other items (below)

Total current assets

291

438

518

649

768

Property, plant & equipment, net

1,929

2,811

3,589

4,505

4,882

Goodwill, net

400

516

557

798

883

## FCFF - why are accrued taxes and expenses added back to net income?

Hi everyone – I’m working on reading 30 ‘Free Cash Flow Valuation’ in the official CFA books.

Had a question on practice problem 2: goal is to calculate FCFF from net income, given financial statements. One of the adjustments made to reach FCFF from net income is to add back ‘accrued taxes and expenses’.

## Equity

There is this classic question of effects of various PnL and Balance Sheet items on FCFF and FCFE.

1st EOC question in Free Cash flow valuation. I checked the forum, still have a doubt on the effect of increase of a 100$ increase in Depreciation.

When depreciation increases by 100, NI decreases by 100(1-t). So we add back this amount while calculating FCFF. Say tax is 40percent. So increase of 100 in depreciation will increase FCFF by 60?

Is this correct?

## Residual Income

Please can someone explain why RI = E - rB ?? The curriculum doesn’t give much explanation as well. Also, whats the difference between cost of equity (ke) and required rate of return (r) ?

## FCFE

In forecasting FCFE by individual components of it. We also forecast the “gross fixed capital investment” and “depreciation” . So, while calculating the net borrowing , why do we take it as the debt ratio multilplied by the net fixed investment (gross fixed cap investment - depreciation), and why not only multiply it by the gross fixed capital investment as that is the amount which is the actual cash borrowed for that fixed capinv and on this cash we are borrowing.

## Schweser MQ31.2

Can someone please explain how to go about this problem? Thanks in advance.

“Creative Toys recently paid a dividend of $1.35 a share. It has a payout ratio of 67%, a ROE of 23%, and an expected growth rate in earnings and dividends for the foreseeable future of 7.6%. Shareholders require a return of 14% on their investment. The justified price to book value multiple is *closest* to:”

## R26 , Q9 CFAII 2019

I’m confused with the answer provided.

A snippet of the question:-

“An active investment manager attempts to capture positive alpha.”

…which of the following sources of perceived mispricing do active managers attempt to identify?

Based on the text in section 2.1.1 intrinsic value, *a perceived mispricing is the difference between estimated intrinsic value and the market price of an asset.*

## Schweser MQ30.2 Question 2

In this question, why do we subtract gains twice (once from FCinv and once for the calculation of non-cash charges)?

The answer calculations in the book:

FCInv = ending net PPE − beginning net PPE + depreciation – gain on sale = 96 − 60 + 27 − 8= $55

NCC = depreciation − gain = 27 − 8 = $19

FCFE = NI + NCC − FCInv − WCInv + net borrowings = 50 + 19 − 55 − 4 + 0 = $10

## Residual Income with ROE approaching r over time

Is it possible to solve this question with a formula? I tried a formula with a persistence factor and couldn’t get the answer. CFAI seems to solve this using Excel and lists a huge table for the solution. PLEASE HELP!

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