CFA Mock Afternoon Session: Equity - Chan Mei Yee/FCFE Item Set

CFA Level II
#1

RE: Question 5 of 6

Yee is also concerned about the effects on McLaughlin’s 2013 FCFE of the following three possible financial actions by McLaughlin during the year 2013:

· Increasing common stock cash dividends by $110 million

· Repurchasing $60 million of common shares

· Reducing its outstanding long-term debt by $100 million

Why is “reducing the LT debt by $100” the answer for the cumulative reduction in FCFE? What about the effect this reduction would have on the interest expense? The explanation for the question doesn’t even mention the interest expense!? Seems like it’s poorly written

#2

FCFE calculation includes net borrowing, paying back loans is a negative net borrowing, thus reduces FCFE

#3

Also, may I ask? In the question, increasing stock cash dividends and repurchasing common stocks do not affect FCFE. Why is that?

#4

FCFE is cash flow available to equityholders before any form of distributions.

i.e. whatever is left after you pay taxes and interest to debtholders.

#5

The answer did explain that cash dividend and share repo are uses of FCFE (it’s funds leftover for the shareholders, so how ever they want to ‘spend it’ is irrelevant in terms of FCFE).

The curriculum did explain this too if you want more details.

#6

Thanks Edbert and keroppi

#7

Thanks Edbert - I guess I wasn’t clear on my question. I get the overall calculation, but I am looking at it this way: the value of Interest Expense x (1-T) is subtracted in the FCFE formula and my issue is that after paying back $100 of debt, your interest expense would be lower and would not result in a dollar for dollar change in FCFE.

#8

I think you are overthinking it.

If you know that FCFE is regarding what’s available for Equity investors, and know that dividend and repurchase are just forms of distributing what’s already theirs, that only leaves debt repayment.

On the other hand, if debt is repaid, that leaves less for equity investors, as cash flow is allocated from equity investors to debt investors.

Regarding your last question: As it does not state, when the debt is repaid in 2013, think of it as on the last day of the fiscal year. That would mean 2013 interest expense is unchanged.

#9

You’re probably right, but I feel like CFAI kinda teaches that. We’re taught to look in the nooks and crannies of financial statements, ethics, equities, et al, and here is a perfect example where I can’t see the obvious answer because I have my massive CFA microscope out.