FCFE

CFA Level II
#1

Dear:

why depreciation has to be netted off with debt financing?

thanks

The following information was collected from the financial statements of the Hiller Corp. for the year ending December 31, 2000:

  • Earnings per share = $4.50.
  • Capital Expenditures per share = $3.00.
  • Depreciation per share = $2.75.
  • Increase in working capital per share = $0.75.
  • Debt financing ratio = 30%.
  • Cost of equity = 12%.

The financial leverage for the firm is expected to be stable.

The FCFE for the base-year will be:

A) $3.00. B) $3.80. C) $4.85.

Your answer: A was incorrect. The correct answer was B) $3.80.

Base-year FCFE = EPS − (capital expenditures − depreciation) × (1 − debt ratio) − increase in working capital × (1 − debt ratio) = $ 4.50 − ($3.00 − $2.75)(1 − 0.30) − $0.75(1 − 0.30) = $3.80.

#2

Well the capital structure of ur firm only increases by the net investment. So to counteract the decrease in leverage u borrow more debt. The debt difference should the ur desire capital structure multiple by the increase in fix asset.

note asset well decrease because of depreciation. So ur equity decrease (depreciation decreases fixed asset n shareholder’s equity) and ur leverage increased.to counteract that you need to buy enough asset to cancel out depreciation. Anymore u did be under leverage n u need to borrow more debt.