maining constant Debt and equity financing, which is the most appropriate valuation? FCFF, FCFE, EVA or RI?
Why does the answer say FCFE??? Shouldn’t that be the least appropriate answer of them all?
Depends on what you are valuing would be one clue. If you are valuing a controlling equity interest and assuming all capex is being financed through issuance of new debt/equity at the target capital structure then FCFE does make sense. Just break down the formula:
CFO - FCI + Net Borrowing. The amount of cash flow left to equity holders would be the cash flow from operations (which includes WCI - which would be financed partially through debt financing) less FCI. Now if you just stopped here you would implicitly be assuming that everything is all equity financed because all of the WCI and FCI would be financed by cash flow that is left to the equity holders. However by maintaining the same capital structure to finance the company’s investments in WC and Fixed Assets “new debt” holders will step in and essentially “reimburse” the equity holders for taking from their cash flow.
No, if you perceive that the company has stable leverage , FCFE is better,
if Debt and leverage policy is unstable , FCFF is better
I don’t know why they’d say that FCFE is better than RI.
We’d probably need the whole context of the question to know for sure, but there might have been something in there that led to a FCF valuation model being preferable, with FCFE being the approriate model given the stable capital structure. Either way, the writer clearly intends to test the difference saurabhm mentioned above.
Would RI be better than FCFE?
I thought that cash flow measures for valuation are the most accurate. However, both FCF and RI rely a lot on good quality of financial reporting.
How do you know there is residual income? Is ROE > r? Based only on what’s expressed you have to go with FCFE the always favor free cash flow and if you know cap structure is table then that tips there hand. Of course a classic CFA question give you some of the needed information and ask you to select the “best” answer
Valuation of what? Firm value or stock price? There are many circumstances in which depends what method will be chosen.
So the main point here is that when debt to equity is stable then you’d use FCFE because that wouldn’t change FCFE that much. When capital structure is unstable you’d use FCFF to truly reflect the valuation of the company since it doesn’t count net borrowings.