An increase in financial leverage, assuming no change in the growth rate, will generally cause a price to cash flow (P/CF) ratio to: A) there is insufficient information to tell. B) decrease. C) increase. **please post your reasoning***
leverage increases, no change in g. 1. modigliani miller says rce would increase. so (rce-g) would increase. P would go down. FCFE would go down bcos Int rate tax shield goes up. So P reduces, FCFE also goes down… not enough info to tell. 2. FCFF is discounted at WACC. WACC goes up - since a. Rce goes up, rd also goes up. g remains same. So (WACC-g) goes up. No impact of leverage on FCFF. FCFF remains the same. So P goes down, due to increase of (WACC-G) FCFF remains same - P/FCFF goes down. all in all, I would think it is Insufficient info to tell.
It depends on what your definition of cash flow is. Are you referring to: FCFF/FCFE CFO EBITDA
The required rate of return and the expected growth rate of future cash flows drive price to cash flow ratios, regardless of how cash flow is defined. All else equal, P/CF values are - Positively related to future cash flow growth rates, inversely related to the required rate of return. Since required rate of return is going up, I would select b.
Decrease An increase in financial leverage should increase the firm’s risk and consequently its required rate of return. This should decrease the P/CF ratio, as indicated by the following expression: P0 / CF0 = (1 + g) / (r – g) (Note: the reading does not allow for any interactive relationship between leverage and growth. Thus, no explicit consideration is given to whether the increase in leverage would increase return on equity (ROE) and therefore growth through the g = (ROE × retention) relationship.)
agreed, break down the multiples to fundamentals
I will say A. Not sufficient information. My reasoning is: P here is the Price of Common Equity (no doubt about that). With increase in leverage, there is a higher risk to Equity Holders and their Re will increase and hence P will come down. Now, CF could be taken as CFO, FCFF or FCFE. CFO and FCFE will decrease with increase in Interest Payments. FCFF will remain the same. Now, if CF is taken as CFO or FCFE, our denominator in P/CF is decreasing. Our numerator P is decreasing anyways, so we cannot say if P/CF will increase or decrease.
rus1bus - exactly what I had written above as well…
Yes CP. Totally agree with your first post.