Scheswer Vol. 2 (2009), PM, Answer 15.6 This might be pretty basic, but I am not getting it for some reason. Question is asking: "Calculation of FCFE will lead to a valuation of the S&P that most likely is: A. Too low if CE is +ve B. Too low if Change in WC is +ve C. too low if proceeds from new debt issues exceed principal debt repayments I chose C which was correct. Explanation given: It says: “NI + dep - Change in WC - CE - Principle Debt repayments + Proceeds from new debt issues = FCFE. (This I understand). Then it goes on to say:” formula will underestimate FCFE if proceeds from new debt issues exceeds principal debt replayments (how?). The other choices A&B will cause the formula to overestimate FCFE (how?). I thought it would be the other way around.
Wasn’t there another part to the question - the analyst is using formula as follows: FCFE = NI + Dep Therefore if Proceeds from debt > repayments this + amount would not be in his calculation so he would have underestimated FCFE Same logic for the other 2 points
Seems wrong to me too. If new debt issues > debt repayments, FCFE will be higher, not understated.
grgkir001 Wrote: ------------------------------------------------------- > Wasn’t there another part to the question - the > analyst is using formula as follows: > FCFE = NI + Dep > > Therefore if Proceeds from debt > repayments this > + amount would not be in his calculation so he > would have underestimated FCFE > > Same logic for the other 2 points just checked and you are correct, so the answer is correct as given by Schweser
Thanks grg, you are right that the question says the analyst is using that particular formula. But isnt that the wrong formula anyway? FCFE is not just the NI + Dep. I was looking at it from the perspective of the whole formula. Why would schweser give us a wrong formula and use that to work out the problem?
no it’s saying if he calculates FCFE using his formula will he over-/underestimate it when compared to using the correct formula. so HIS calculation would be: if CE is positive - he would not have accounted for CE so his FCFE would be too high because he wouldn’t have deducted it if change in WC is positive - he ouwld not have deducted this from FCFE so his FCFE would be higher if proceeds from new debt > repayments - he would not have added this so his would be too low. Options per question: A. Too low if CE is +ve B. Too low if Change in WC is +ve C. too low if proceeds from new debt issues exceed principal debt repayments So C is the only one that fits…make more sense?
u da man grg…thanks !!