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Question 278 inflation, real and nominal returns and cash flows

Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year.

Question 992 inflation, real and nominal returns and cash flows

You currently have $100 in the bank which pays a 10% pa interest rate.

Oranges currently cost $1 each at the shop and inflation is 5% pa which is the expected growth rate in the orange price.

This information is summarised in the table below, with some parts missing that correspond to the answer options. All rates are given as effective annual rates. Note that when payments are not specified as real, as in this question, they're conventionally assumed to be nominal.

Wealth in Dollars and Oranges
Time (year)	Bank account wealth ($)	Orange price ($)	Wealth in oranges
0	100	1	100
1	110	1.05	(a)
2	(b)	(c)	(d)

Which of the following statements is NOT correct? Your:

Question 295 inflation, real and nominal returns and cash flows, NPV

When valuing assets using discounted cash flow (net present value) methods, it is important to consider inflation. To properly deal with inflation:

(I) Discount nominal cash flows by nominal discount rates.

(II) Discount nominal cash flows by real discount rates.

(III) Discount real cash flows by nominal discount rates.

(IV) Discount real cash flows by real discount rates.

Which of the above statements is or are correct?

Question 734 real and nominal returns and cash flows, inflation, DDM, no explanation

An equities analyst is using the dividend discount model to price a company's shares. The company operates domestically and has no plans to expand overseas. It is part of a mature industry with stable positive growth prospects.

The analyst has estimated the real required return (r) of the stock and the value of the dividend that the stock just paid a moment before ##(C_\text{0 before})##.

What is the highest perpetual real growth rate of dividends (g) that can be justified? Select the most correct statement from the following choices. The highest perpetual real expected growth rate of dividends that can be justified is the country's expected:

Question 1022 inflation linked bond, breakeven inflation rate, inflation, real and nominal returns and cash flows

Below is a graph of 10-year US treasury fixed coupon bond yields (red), inflation-indexed bond yields (green) and the 'breakeven' inflation rate (blue). Note that inflation-indexed bonds are also called treasury inflation protected securities (TIPS) in the US. In other countries they're called inflation-linked bonds (ILB's). For more information, see PIMCO's great article about inflation linked bonds here.

The 10 year breakeven inflation rate (blue) equals the:

Question 1024 inflation linked bond, bond pricing

PIMCO gives the following example of an Inflation Linked Bond (ILB), called Treasury Inflation Protected Securities (TIPS) in the US.

How do ILBs work?

An ILB’s explicit link to a nationally-recognized inflation measure means that any increase in price levels directly translates into higher principal values. As a hypothetical example, consider a $1,000 20-year U.S. TIPS with a 2.5% coupon (1.25% on semiannual basis), and an inflation rate of 4%. The principal on the TIPS note will adjust upward on a daily basis to account for the 4% inflation rate. At maturity, the principal value will be $2,208 (4% per year, compounded semiannually). Additionally, while the coupon rate remains fixed at 2.5%, the dollar value of each interest payment will rise, as the coupon will be paid on the inflation-adjusted principal value. The first semiannual coupon of 1.25% paid on the inflation-adjusted principal of $1,020 is $12.75, while the final semiannual interest payment will be 1.25% of $2,208, which is $27.60.

Forecast the semi-annual coupon paid in 10 years based on the bond details given above. The 20th semi-annual coupon, paid in 10 years, is expected to be:

Question 1023 monetary policy, inflation, breakeven inflation rate

If the breakeven inflation rate was far above the US Fed's long term 2% average inflation target, the Fed would be expected to:

Question 1015 RBA cash rate, monetary policy

Former Reserve Bank of Australia (RBA) Governor Phil Lowe says that the RBA cash rate is the interest rate in the Australian:

Question 1016 RBA cash rate, monetary policy

Former RBA Governor Phil Lowe says that if the economy is growing very strongly, then prices might be growing too:

Question 1017 RBA cash rate, monetary policy

Former RBA Governor Phil Lowe says that when the RBA raise interest rates, homeowners' mortgage loan interest expense will be:

Question 1018 RBA cash rate, monetary policy, foreign exchange rate

RBA Governor Phil Lowe says that when the RBA raises the cash rate (by surprise), the Australian dollar (AUD) tends to:

Question 1019 RBA cash rate, monetary policy, wealth effect

Former RBA Governor Phil Lowe says that when the RBA raise the cash rate, asset prices tend to:

Question 1020 Federal funds rate, monetary policy, dot plot

US Federal Reserve Chair Jerome Powell showed the 'dot plot' of Federal Open Market Committee (FOMC) members' estimated future Fed fund rates following their quarterly summary of economic projections on 15 Dec 2021. The dot plot shows that committee members intended to make monetary policy more:

Question 1021 Federal funds rate, monetary policy, quantitative easing, tapering

US Fed Chair Jerome Powell held a news conference following the 25-26 January 2022 FOMC meeting.

Nick Timiraos reporting for The Wall Street Journal asked: "Raising rates and reducing the balance sheet both restrain the economy, both tighten monetary policy. How should we think about the relationship between the two? For example, how much passive runoff is equal to every quarter percentage point increase in your benchmark rate?"

Jerome Powell replied: "So, again, we think of the balance sheet as moving in a predictable manner, sort of in the background, and that the active tool meeting to meeting is not -- both of them, it's the federal funds rate. There are rules of thumbs. I'm reluctant to land on one of them that equate this. And there's also an element of uncertainty around the balance sheet. I think we have a much better sense, frankly, of how rate increases affect financial conditions and, hence, economic conditions. Balance sheet is still a relatively new thing for the markets and for us, so we're less certain about that." (US Fed, 2022)

When Nick Timiraos mentioned 'reducing the balance sheet', he's referring to:

(a) Quantitative easing (QE), where the US Fed increases its asset purchases. For example, by buying more US government bonds each month, increasing demand for bonds, raising their price and lowering their yield.

(b) Tapering, where the US Fed decreases its asset purchases. For example, by buying less US government bonds each month, decreasing demand for bonds, lowering their price and raising their yield.

(d) Contractionary conventional monetary policy, where the US Federal Reserve lowers the Fed funds rate.

(e) Expansionary non-conventional monetary policy, where the US Federal Reserve reduces its assets through the purchase of more US government bonds, increasing the US Federal Reserve's liabilities.

Question 348 PE ratio, Multiples valuation

Estimate the US bank JP Morgan's share price using a price earnings (PE) multiples approach with the following assumptions and figures only:

The major US banks JP Morgan Chase (JPM), Citi Group (C) and Wells Fargo (WFC) are comparable companies;
JP Morgan Chase's historical earnings per share (EPS) is $4.37;
Citi Group's share price is $50.05 and historical EPS is $4.26;
Wells Fargo's share price is $48.98 and historical EPS is $3.89.

Note: Figures sourced from Google Finance on 24 March 2014.

Question 354 PE ratio, Multiples valuation

Which firms tend to have low forward-looking price-earnings (PE) ratios?

Only consider firms with positive earnings, disregard firms with negative earnings and therefore negative PE ratios.

Question 357 PE ratio, Multiples valuation

Which of the following investable assets are NOT suitable for valuation using PE multiples techniques?

Question 358 PE ratio, Multiples valuation

Estimate the Chinese bank ICBC's share price using a backward-looking price earnings (PE) multiples approach with the following assumptions and figures only. Note that the renminbi (RMB) is the Chinese currency, also known as the yuan (CNY).

The 4 major Chinese banks ICBC, China Construction Bank (CCB), Bank of China (BOC) and Agricultural Bank of China (ABC) are comparable companies;
ICBC 's historical earnings per share (EPS) is RMB 0.74;
CCB's backward-looking PE ratio is 4.59;
BOC 's backward-looking PE ratio is 4.78;
ABC's backward-looking PE ratio is also 4.78;

Note: Figures sourced from Google Finance on 25 March 2014. Share prices are from the Shanghai stock exchange.

Question 463 PE ratio, Multiples valuation

Private equity firms are known to buy medium sized private companies operating in the same industry, merge them together into a larger company, and then sell it off in a public float (initial public offering, IPO).

If medium-sized private companies trade at PE ratios of 5 and larger listed companies trade at PE ratios of 15, what return can be achieved from this strategy?

Assume that:

The medium-sized companies can be bought, merged and sold in an IPO instantaneously.
There are no costs of finding, valuing, merging and restructuring the medium sized companies. Also, there is no competition to buy the medium-sized companies from other private equity firms.
The large merged firm's earnings are the sum of the medium firms' earnings.
The only reason for the difference in medium and large firm's PE ratios is due to the illiquidity of the medium firms' shares.
Return is defined as: ##r_{0→1} = (p_1-p_0+c_1)/p_0## , where time zero is just before the merger and time one is just after.

Question 537 PE ratio, Multiples valuation, no explanation

Estimate the French bank Societe Generale's share price using a backward-looking price earnings (PE) multiples approach with the following assumptions and figures only. Note that EUR is the euro, the European monetary union's currency.

The 4 major European banks Credit Agricole (ACA), Deutsche Bank AG (DBK), UniCredit (UCG) and Banco Santander (SAN) are comparable companies to Societe Generale (GLE);
Societe Generale's (GLE's) historical earnings per share (EPS) is EUR 2.92;
ACA's backward-looking PE ratio is 16.29 and historical EPS is EUR 0.84;
DBK's backward-looking PE ratio is 25.01 and historical EPS is EUR 1.26;
SAN's backward-looking PE ratio is 14.71 and historical EPS is EUR 0.47;
UCG's backward-looking PE ratio is 15.78 and historical EPS is EUR 0.40;

Note: Figures sourced from Google Finance on 27 March 2015.

Question 749 Multiples valuation, PE ratio, price to revenue ratio, price to book ratio, NPV

A real estate agent says that the price of a house in Sydney Australia is approximately equal to the gross weekly rent times 1000.

What type of valuation method is the real estate agent using?

Question 935 real estate, NPV, perpetuity with growth, multi stage growth model, DDM

You're thinking of buying an investment property that costs $1,000,000. The property's rent revenue over the next year is expected to be $50,000 pa and rent expenses are $20,000 pa, so net rent cash flow is $30,000. Assume that net rent is paid annually in arrears, so this next expected net rent cash flow of $30,000 is paid one year from now.

The year after, net rent is expected to fall by 2% pa. So net rent at year 2 is expected to be $29,400 (=30,000*(1-0.02)^1).

The year after that, net rent is expected to rise by 1% pa. So net rent at year 3 is expected to be $29,694 (=30,000*(1-0.02)^1*(1+0.01)^1).

From year 3 onwards, net rent is expected to rise at 2.5% pa forever. So net rent at year 4 is expected to be $30,436.35 (=30,000*(1-0.02)^1*(1+0.01)^1*(1+0.025)^1).

Assume that the total required return on your investment property is 6% pa. Ignore taxes. All returns are given as effective annual rates.

What is the net present value (NPV) of buying the investment property?

Question 990 Multiples valuation, EV to EBITDA ratio, enterprise value

A firm has:

2 million shares;

$200 million EBITDA expected over the next year;

$100 million in cash (not included in EV);

1/3 market debt-to-assets ratio is (market assets = EV + cash);

4% pa expected dividend yield over the next year, paid annually with the next dividend expected in one year;

2% pa expected dividend growth rate;

40% expected payout ratio over the next year;

10 times EV/EBITDA ratio.

30% corporate tax rate.

The stock can be valued using the EV/EBITDA multiple, dividend discount model, Gordon growth model or PE multiple. Which of the below statements is NOT correct based on an EV/EBITDA multiple valuation?

Question 238 CFFA, leverage, interest tax shield

A company increases the proportion of debt funding it uses to finance its assets by issuing bonds and using the cash to repurchase stock, leaving assets unchanged.

Ignoring the costs of financial distress, which of the following statements is NOT correct:

Question 344 CFFA, capital budgeting

A new company's Firm Free Cash Flow (FFCF, same as CFFA) is forecast in the graph below.

To value the firm's assets, the terminal value needs to be calculated using the perpetuity with growth formula:

###V_{\text{terminal, }t-1} = \dfrac{FFCF_{\text{terminal, }t}}{r-g}###

Which point corresponds to the best time to calculate the terminal value?

Question 766 CFFA, WACC, interest tax shield, DDM

Use the below information to value a levered company with constant annual perpetual cash flows from assets. The next cash flow will be generated in one year from now, so a perpetuity can be used to value this firm. Both the operating and firm free cash flows are constant (but not equal to each other).

Data on a Levered Firm with Perpetual Cash Flows
Item abbreviation	Value	Item full name
##\text{OFCF}##	$100m	Operating free cash flow
##\text{FFCF or CFFA}##	$112m	Firm free cash flow or cash flow from assets (includes interest tax shields)
##g##	0% pa	Growth rate of OFCF and FFCF
##\text{WACC}_\text{BeforeTax}##	7% pa	Weighted average cost of capital before tax
##\text{WACC}_\text{AfterTax}##	6.25% pa	Weighted average cost of capital after tax
##r_\text{D}##	5% pa	Cost of debt
##r_\text{EL}##	9% pa	Cost of levered equity
##D/V_L##	50% pa	Debt to assets ratio, where the asset value includes tax shields
##t_c##	30%	Corporate tax rate

What is the value of the levered firm including interest tax shields?

Question 773 CFFA, WACC, interest tax shield, DDM

Data on a Levered Firm with Perpetual Cash Flows
Item abbreviation	Value	Item full name
##\text{OFCF}##	$48.5m	Operating free cash flow
##\text{FFCF or CFFA}##	$50m	Firm free cash flow or cash flow from assets
##g##	0% pa	Growth rate of OFCF and FFCF
##\text{WACC}_\text{BeforeTax}##	10% pa	Weighted average cost of capital before tax
##\text{WACC}_\text{AfterTax}##	9.7% pa	Weighted average cost of capital after tax
##r_\text{D}##	5% pa	Cost of debt
##r_\text{EL}##	11.25% pa	Cost of levered equity
##D/V_L##	20% pa	Debt to assets ratio, where the asset value includes tax shields
##t_c##	30%	Corporate tax rate

What is the value of the levered firm including interest tax shields?

Question 804 CFFA, WACC, interest tax shield, DDM

Use the below information to value a levered company with annual perpetual cash flows from assets that grow. The next cash flow will be generated in one year from now. Note that ‘k’ means kilo or 1,000. So the $30k is $30,000.

Data on a Levered Firm with Perpetual Cash Flows
Item abbreviation	Value	Item full name
##\text{OFCF}##	$30k	Operating free cash flow
##g##	1.5% pa	Growth rate of OFCF
##r_\text{D}##	4% pa	Cost of debt
##r_\text{EL}##	16.3% pa	Cost of levered equity
##D/V_L##	80% pa	Debt to assets ratio, where the asset value includes tax shields
##t_c##	30%	Corporate tax rate
##n_\text{shares}##	100k	Number of shares

Which of the following statements is NOT correct?

Question 1004 CFFA, WACC, interest tax shield, DDM

Use the below information to value a mature levered company with growing annual perpetual cash flows and a constant debt-to-assets ratio. The next cash flow will be generated in one year from now, so a perpetuity can be used to value this firm. The firm's debt funding comprises annual fixed coupon bonds that all have the same seniority and coupon rate. When these bonds mature, new bonds will be re-issued, and so on in perpetuity. The yield curve is flat.

Data on a Levered Firm with Perpetual Cash Flows
Item abbreviation	Value	Item full name
##\text{OFCF}_1##	$12.5m	Operating free cash flow at time 1
##\text{FFCF}_1 \text{ or }\text{CFFA}_1##	$14m	Firm free cash flow or cash flow from assets at time 1
##\text{EFCF}_1##	$11m	Equity free cash flow at time 1
##\text{BondCoupons}_1##	$1.2m	Bond coupons paid to debt holders at time 1
##g##	2% pa	Growth rate of OFCF, FFCF, EFCF and Debt cash flow
##\text{WACC}_\text{BeforeTax}##	9% pa	Weighted average cost of capital before tax
##\text{WACC}_\text{AfterTax}##	8.25% pa	Weighted average cost of capital after tax
##r_\text{D}##	5% pa	Bond yield
##r_\text{EL}##	13% pa	Cost or required return of levered equity
##D/V_L##	50% pa	Debt to assets ratio, where the asset value includes tax shields
##n_\text{shares}##	1m	Number of shares
##t_c##	30%	Corporate tax rate

Which of the following statements is NOT correct?

Question 273 CFFA, capital budgeting

Value the following business project to manufacture a new product.

Project Data
Project life	2 yrs
Initial investment in equipment	$6m
Depreciation of equipment per year	$3m
Expected sale price of equipment at end of project	$0.6m
Unit sales per year	4m
Sale price per unit	$8
Variable cost per unit	$5
Fixed costs per year, paid at the end of each year	$1m
Interest expense per year	0
Tax rate	30%
Weighted average cost of capital after tax per annum	10%

Notes

The firm's current assets and current liabilities are $3m and $2m respectively right now. This net working capital will not be used in this project, it will be used in other unrelated projects.
Due to the project, current assets (mostly inventory) will grow by $2m initially (at t = 0), and then by $0.2m at the end of the first year (t=1).
Current liabilities (mostly trade creditors) will increase by $0.1m at the end of the first year (t=1).
At the end of the project, the net working capital accumulated due to the project can be sold for the same price that it was bought.
The project cost $0.5m to research which was incurred one year ago.

Assumptions

All cash flows occur at the start or end of the year as appropriate, not in the middle or throughout the year.
All rates and cash flows are real. The inflation rate is 3% pa.
All rates are given as effective annual rates.
The business considering the project is run as a 'sole tradership' (run by an individual without a company) and is therefore eligible for a 50% capital gains tax discount when the equipment is sold, as permitted by the Australian Tax Office.

What is the expected net present value (NPV) of the project?

Question 301 leverage, capital structure, real estate

Your friend just bought a house for $1,000,000. He financed it using a $900,000 mortgage loan and a deposit of $100,000.

In the context of residential housing and mortgages, the 'equity' or 'net wealth' tied up in a house is the value of the house less the value of the mortgage loan. Assuming that your friend's only asset is his house, his net wealth is $100,000.

If house prices suddenly fall by 15%, what would be your friend's percentage change in net wealth?

Assume that:

No income (rent) was received from the house during the short time over which house prices fell.
Your friend will not declare bankruptcy, he will always pay off his debts.

Question 406 leverage, WACC, margin loan, portfolio return

One year ago you bought $100,000 of shares partly funded using a margin loan. The margin loan size was $70,000 and the other $30,000 was your own wealth or 'equity' in the share assets.

The interest rate on the margin loan was 7.84% pa.

Over the year, the shares produced a dividend yield of 4% pa and a capital gain of 5% pa.

What was the total return on your wealth? Ignore taxes, assume that all cash flows (interest payments and dividends) were paid and received at the end of the year, and all rates above are effective annual rates.

Hint: Remember that wealth in this context is your equity (E) in the house asset (V = D+E) which is funded by the loan (D) and your deposit or equity (E).

Question 408 leverage, portfolio beta, portfolio risk, real estate, CAPM

You just bought a house worth $1,000,000. You financed it with an $800,000 mortgage loan and a deposit of $200,000.

You estimate that:

The house has a beta of 1;
The mortgage loan has a beta of 0.2.

What is the beta of the equity (the $200,000 deposit) that you have in your house?

Also, if the risk free rate is 5% pa and the market portfolio's return is 10% pa, what is the expected return on equity in your house? Ignore taxes, assume that all cash flows (interest payments and rent) were paid and received at the end of the year, and all rates are effective annual rates.

Question 800 leverage, portfolio return, risk, portfolio risk, capital structure, no explanation

Which of the following assets would you expect to have the highest required rate of return? All values are current market values.

Question 69 interest tax shield, capital structure, leverage, WACC

Which statement about risk, required return and capital structure is the most correct?

(a) The before-tax cost of debt is less than the before-tax cost of equity. Therefore debt is a cheaper form of financing than equity so companies should try to finance their projects with debt only.

(b) Debt makes a firm's equity more risky. Therefore the higher the amount of debt, the higher the cost of equity.

(c) The more debt a firm has, the higher its tax shields. Therefore firms should seek to have as much debt and as little equity as possible.

(d) The more debt, the lower the firm's after tax WACC. The after tax WACC is the discount rate that discounts the firm's cash flows, so the lower it is the more the firm is worth. Therefore firms should try to make their after tax WACC as low as possible by using as much debt as possible.

(e) The less debt, the lower the chance of bankruptcy. Therefore firms should try to pay off all of their debt so that they are financed by equity only.

Question 94 leverage, capital structure, real estate

Your friend just bought a house for $400,000. He financed it using a $320,000 mortgage loan and a deposit of $80,000.

In the context of residential housing and mortgages, the 'equity' tied up in the value of a person's house is the value of the house less the value of the mortgage. So the initial equity your friend has in his house is $80,000. Let this amount be E, let the value of the mortgage be D and the value of the house be V. So ##V=D+E##.

If house prices suddenly fall by 10%, what would be your friend's percentage change in equity (E)? Assume that the value of the mortgage is unchanged and that no income (rent) was received from the house during the short time over which house prices fell.

Remember:

### r_{0\rightarrow1}=\frac{p_1-p_0+c_1}{p_0} ###

where ##r_{0-1}## is the return (percentage change) of an asset with price ##p_0## initially, ##p_1## one period later, and paying a cash flow of ##c_1## at time ##t=1##.

Question 115 capital structure, leverage, WACC

A firm has a debt-to-assets ratio of 50%. The firm then issues a large amount of debt to raise money for new projects of similar market risk to the company's existing projects. Assume a classical tax system. Which statement is correct?

Question 337 capital structure, interest tax shield, leverage, real and nominal returns and cash flows, multi stage growth model

A fast-growing firm is suitable for valuation using a multi-stage growth model.

It's nominal unlevered cash flow from assets (##CFFA_U##) at the end of this year (t=1) is expected to be $1 million. After that it is expected to grow at a rate of:

12% pa for the next two years (from t=1 to 3),
5% over the fourth year (from t=3 to 4), and
-1% forever after that (from t=4 onwards). Note that this is a negative one percent growth rate.

Assume that:

The nominal WACC after tax is 9.5% pa and is not expected to change.
The nominal WACC before tax is 10% pa and is not expected to change.
The firm has a target debt-to-equity ratio that it plans to maintain.
The inflation rate is 3% pa.
All rates are given as nominal effective annual rates.

What is the levered value of this fast growing firm's assets?

Question 376 leverage, capital structure, no explanation

Question 377 leverage, capital structure

Question 379 leverage, capital structure, payout policy

Question 380 leverage, capital structure

Question 506 leverage, accounting ratio

A firm has a debt-to-equity ratio of 25%. What is its debt-to-assets ratio?

Question 507 leverage, accounting ratio

A firm has a debt-to-equity ratio of 60%. What is its debt-to-assets ratio?

Question 663 leverage, accounting ratio

A firm has a debt-to-assets ratio of 20%. What is its debt-to-equity ratio?

Question 772 interest tax shield, capital structure, leverage

A firm issues debt and uses the funds to buy back equity. Assume that there are no costs of financial distress or transactions costs. Which of the following statements about interest tax shields is NOT correct?

Question 774 leverage, WACC, real estate

One year ago you bought a $1,000,000 house partly funded using a mortgage loan. The loan size was $800,000 and the other $200,000 was your wealth or 'equity' in the house asset.

The interest rate on the home loan was 4% pa.

Over the year, the house produced a net rental yield of 2% pa and a capital gain of 2.5% pa.

Assuming that all cash flows (interest payments and net rental payments) were paid and received at the end of the year, and all rates are given as effective annual rates, what was the total return on your wealth over the past year?

Hint: Remember that wealth in this context is your equity (E) in the house asset (V = D+E) which is funded by the loan (D) and your deposit or equity (E).

Question 799 LVR, leverage, accounting ratio

In the home loan market, the acronym LVR stands for Loan to Valuation Ratio. If you bought a house worth one million dollars, partly funded by an $800,000 home loan, then your LVR was 80%. The LVR is equivalent to which of the following ratios?

Question 802 negative gearing, leverage, capital structure, no explanation

Which of the following statements about ‘negative gearing’ is NOT correct?

Question 1008 WACC, leverage, CFFA, EFCF

An analyst is valuing a levered company whose owners insist on keeping a constant market debt to assets ratio into the future.

The analyst is wondering how asset values and other things in her model will change when she changes the forecast sales growth rate.

Which of the below values will increase as the forecast growth rate of sales increases, with the debt to assets ratio remaining constant?

Assume that the cost of debt (yield) remains constant and the company’s asset beta will also remain constant since any expansion (or downsize) will involve buying (or selling) more of the same assets.

The analyst should expect which value or ratio to increase when the forecast growth rate of sales increases and the debt to assets ratio remains unchanged? In other words, which of the following values will NOT remain constant?

Question 1007 WACC, leverage, CFFA, EFCF

An analyst is valuing a levered company whose owners insist on keeping the dollar amount of debt funding fixed. So the company cannot issue or repay its debt, its dollar value must remain constant. Any funding gaps will be met with equity.

The analyst is wondering, as he changes inputs into his valuation, such as the forecast growth rate of sales, then asset values and other things will change. This makes it hard to figure out which values can be held constant and would therefore make good model inputs, rather than outputs which vary depending on the inputs. Assume that the cost of debt (yield) remains constant and the company’s asset beta will also remain constant since any expansion (or downsize) will involve buying (or selling) more of the same assets.

Which of the following values can be assumed to stay constant when projected sales growth increases?

Question 1031 Multiples valuation

Investment bank Canaccord's Think Childcare (TNK) initiation of coverage states: "What's the Differentiator? TNK are operators, not consolidators - Other listed childcare companies have led highly successful consolidation strategies involving multiple arbitrage combined with scale benefits and operating efficiencies. TNK’s focus is on operating the centres to the best of their individual potentials..." (Canaccord, 2016). Multiples arbitrage involves:

Question 1032 inflation, percent of sales forecasting, no explanation

Investment bank Canaccord's Think Childcare (TNK) initiation of coverage states: "Building lease costs – Rent expense is the second largest cost and TNK reported rent/sales of 12.1%, within the industry range that we typically see as 12-14% of sales. TNK lease all their properties and do not intend to own property. Leases are generally long term with 10-15 year terms and additional options. Although terms vary across properties and landlords, rental increases are generally tied to the consumer price index (CPI)" (Canaccord, 2016).

Assuming that sales grow faster than the CPI, when Canaccord forecast TNK's building lease costs using the 'percent of sales' method, that proportion should:

Question 1030 Multiples valuation, no explanation

Read these quotes from Adir Shiffman's 26 July 2021 article in the AFR 'Roll up, roll up and make a mint off Amazon sellers'.

"Amazon sellers outsource their warehousing and logistics to the tech giant in a model known as “fulfilled by Amazon”, or FBA. Joining FBA provides access to one of the world’s largest global warehousing operations and even a fleet of Boeing 747 cargo jets. Just as significantly, FBA sellers can much more easily qualify for Amazon’s Prime program, which guarantees free and fast shipping to members."

"Companies want to acquire and integrate a selection, or in business parlance, do a 'roll-up'."

"More than 100 companies are now racing to roll-up FBA sellers, and almost all have launched since 2017. At least a dozen of these boast war chests of more than $US100 million. The largest, Thrasio, was founded in 2018 and has raised more than $US1.7 billion. Thrasio targets businesses with high quality and differentiated products that generate $US1 to $US100 million in revenue annually" (Shiffman, 2021).

If Thrasio's total funds available to spend on the roll up is $1.7 billion, and it's buying targets at price-to-revenue multiples of 2, what's the largest number of firms with $50 million of annual revenue that it could buy?

Question 1025 real and nominal returns and cash flows

What proportion of managers are evaluating projects correctly, based on table 8 from Meier and Tarhan's (2006) survey of corporate managers?

Table 8: Consistency of nominal or real hurdle rates and cash flows
Hurdle rate	Cash flows		Total
Hurdle rate	Nominal	Real	Total
Nominal	29.8%	11.6%	41.3%
Real	19.8%	38.4%	58.7%
Total	49.6%	50.4%	100.0%

Table 8 footnote: The rows in this cross-tabulation show whether the firm uses a nominal or real hurdle rate, the columns indicate whether cash flows are calculated in nominal or real terms. The fractions denote the number of firms for each combination relative to the total of 123 respondents that responded to both separate survey questions.

What proportion of managers are evaluating projects correctly?

Question 1026 CFFA, WACC, interest tax shield

Meier and Tarhan (2006) conducted an interesting survey of corporate managers. The results are copied in Table 7 below. What proportion of managers are evaluating levered projects correctly?

Table 7: Consistency between hurdle rate and the calculation of cash flows
Hurdle rate	Cash flow calculation (see below notes)
Hurdle rate	(i)	(ii)	(iii)	(iv)	(v)	Other	Total
WACC	11.3%	34.8%	1.7%	3.5%	18.3%	1.7%	71.3%
Equity levered	0.0%	2.6%	0.9%	0.0%	0.9%	0.9%	6.1%
Equity unlevered	1.7%	1.7%	0.9%	0.9%	1.7%	0.9%	7.8%
Other	2.6%	5.2%	1.7%	0.9%	3.5%	0.9%	14.8%
Total	16.5%	44.4%	5.2%	5.2%	24.4%	4.4%	100.0%

The rows of the cross-tabulation indicate what the self-reported hurdle rate represents and the columns denote five different ways to calculate cash flows, (i) to (v), plus the “other” category. Each cell then displays the fraction of all 113 respondents for a given combination of what the hurdle rate represents and how the firm calculates its cash flows when evaluating a project.

The definitions of the cash flow calculations (i)-(v) are as follows:

(i) Earnings before interest and after taxes (EBIAT) + depreciation

(ii) Earnings before interest and after taxes (EBIAT) + depreciation – capital expenditures – net change in working capital

(iii) Earnings

(iv) Earnings + depreciation

(v) Earnings + depreciation – capital expenditures – net change in working capital

Assume that the WACC is after tax, the required return on unlevered equity is the WACC before tax, all projects are levered, the benefit of interest tax shields should be included in the valuation, earnings = net profit after tax (NPAT) and EBIAT = EBIT*(1-tc) which is often also called net operating profit after tax (NOPAT).

What proportion of managers are evaluating levered projects correctly?

Question 1027 duration

Below is a table showing GMO's 2016 estimates of different assets' durations, appearing in Slater (2017).

If you were certain that interest rates would fall more than the market expects, into what asset might you allocate more funds?

Question 1028 duration, beta, CAPM, DDM

A stock has a beta of 0.5. Its next dividend is expected to be $3, paid one year from now. Dividends are expected to be paid annually and grow by 2% pa forever. Treasury bonds yield 3% pa and the market risk premium (MRP) is 6% pa. All returns are effective annual rates.

Which of the following statements is NOT correct?

Question 905 market capitalisation of equity, PE ratio, payout ratio

The below graph shows the computer software company Microsoft's stock price (MSFT) at the market close on the NASDAQ on Friday 1 June 2018.

Based on the screenshot above, which of the following statements about MSFT is NOT correct? MSFT's:

Question 1039 gross domestic product, inflation, business cycle

In this business cycle graph shown in the RBA's article explaining recessions, how might 'output' on the y-axis be measured?

The ‘output’ y-axis amount in the business cycle chart can be measured by:

Question 1040 monetary policy, business cycle

Question 1041 monetary policy, business cycle

Question 1042 monetary policy, business cycle

Question 852 gross domestic product, inflation, employment, no explanation

When the economy is booming (in an upswing), you tend to see:

Question 840 gross domestic product

Calculate Australia’s GDP over the 2016 calendar year using the below table:

Australian Gross Domestic Product Components
A$ billion, 2016 Calendar Year from 1 Jan 2016 to 31 Dec 2016 inclusive
Consumption	Investment	Government spending	Exports	Imports
971	421	320	328	344

Source: ABS 5206.0 Australian National Accounts: National Income, Expenditure and Product. Table 3. Expenditure on Gross Domestic Product (GDP), Current prices.

Over the 2016 calendar year, Australia’s GDP was:

Question 850 gross domestic product, gross domestic product per capita

Below is a table showing some countries’ GDP, population and GDP per capita.

Countries' GDP and Population
	GDP	Population	GDP per capita
	USD million	millions of people	USD
United States	18,036,648	325	55,492
China	11,158,457	1,383	8,066
Japan	4,383,076	127	34,586
Germany	3,363,600	83	40,623
Norway	500,519	5	95,027

Source: "GDP and its breakdown at current prices in US Dollars" United Nations Statistics Division. December 2016.

Using this data only, which one of these countries’ citizens have the highest living standards?

Question 853 gross domestic product

Which form of production is included in the Gross Domestic Product (GDP) reported by the government statistics agency?

Question 1035 Minsky financial instability hypothesis, leverage

Which of the following statements about 'The Financial Instability Hypothesis' (Minsky, 1992) is NOT correct? Borrowers with sufficient income to pay:

Question 1036 Minsky financial instability hypothesis, leverage

Hyman Minsky, author of 'The Financial Instability Hypothesis' (1992), wrote:

In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values.

Which of the below statements explaining this quote is NOT correct?

Question 1037 gross domestic product, no explanation

What effect is being referred to in the following quote from the MARTIN model description?  

Economy-wide models also account for feedback between economic variables. For example, an increase in aggregate demand will encourage firms to hire more workers, which raises employment and lowers the unemployment rate. The tightening of the labour market is likely to lead to an increase in wages growth. The resulting increase in household incomes is likely to lead to an increase in consumption, further raising aggregate demand. (Ballantyne et al, 2019)

The name of the effect being referred to is:

Question 1038 fire sale, leverage, no explanation

Listen to 'Lessons and Questions from the GFC' on 6 December 2018 by RBA Deputy Governor Guy Debelle from 17:58 to 20:08 or read the below transcript:

Guy Debelle talks about the GFC and says that the Australian government’s guarantee of wholesale debt and deposits on 12 October 2008 was "introduced to facilitate the flow of credit to the real economy at a reasonable price and, in some cases, alleviate the need for asset fire sales, which have the capacity to tip markets and the economy into a worse equilibrium... The crisis very much demonstrated the critical importance of keeping the lending flowing. The lesson is that countries that did that fared better than countries that didn't. That lesson is relevant to the situation today in Australia, where there is a risk that a reduced appetite to lend will overly curtail borrowing with consequent effects for the Australian economy." (Debelle, 2019)

When assets are sold in a fire sale, there’s usually a large increase in the:

Question 1034 duration, monetary policy, inflation, market efficiency

On 18 March 2022 the AFR's James Thomson wrote: "In a world where the bombs are still falling in Ukraine and the Fed is just getting started on what looks likely to be a year-long cycle of rising interest rates, it would take a certain amount of bravery to embrace the sort of high-tech, long duration plays that Wood favours" (Thomson, 2022).

Which of the following US macro-economic data releases is most likely to cause Cathie Wood's ARK ETF share price to fall?

Question 325 foreign exchange rate

In the 1997 Asian financial crisis many countries' exchange rates depreciated rapidly against the US dollar (USD). The Thai, Indonesian, Malaysian, Korean and Filipino currencies were severely affected. The below graph shows these Asian countries' currencies in USD per one unit of their currency, indexed to 100 in June 1997.

Image of Asian currencies in the 1997 Asian financial crisis, sourced from the RBA

Of the statements below, which is NOT correct? The Asian countries':

Question 882 Asian currency crisis, foreign exchange rate, original sin, no explanation

In the 1997 Asian currency crisis, the businesses most vulnerable to bankruptcy were those that:

Question 986 initial public offering, capital raising

In an initial public offering (IPO), a:

Question 1013 book build, initial public offering, capital raising, demand schedule

A firm is floating its stock in an IPO and its underwriter has received the following bids, listed in order from highest to lowest share price:

IPO Book Build Bids
Bidders	Share price	Number of shares
	$/share	millions
BidderA	2.5	2
BidderB	2	1.5
BidderC	1.5	4
BidderD	1	3
BidderE	0.5	2

Suppose that the firm's owner wishes to sell all of their 8 million shares, so no new money will be raised and no money will re-invested back into the firm. Which of the following statements is NOT correct?

Question 1014 book build, initial public offering, capital raising, demand schedule

A firm is floating its stock in an IPO and its underwriter has received the following bids, listed in order from highest to lowest share price:

IPO Book Build Bids
Bidders	Share price	Number of shares
	$/share	millions
BidderA	2.5	2
BidderB	2	1.5
BidderC	1.5	4
BidderD	1	3
BidderE	0.5	2

Suppose that the firm's owner wishes to raise $6 million to expand the business by selling new stock in the initial public offering (IPO). The owner currently holds 8 million stock which are not for sale. Which of the following statements is NOT correct?

Question 568 rights issue, capital raising, capital structure

A company conducts a 1 for 5 rights issue at a subscription price of $7 when the pre-announcement stock price was $10. What is the percentage change in the stock price and the number of shares outstanding? The answers are given in the same order. Ignore all taxes, transaction costs and signalling effects.

Question 666 rights issue, capital raising

A company conducts a 2 for 3 rights issue at a subscription price of $8 when the pre-announcement stock price was $9. Assume that all investors use their rights to buy those extra shares.

What is the percentage increase in the stock price and the number of shares outstanding? The answers are given in the same order.

Question 788 rights issue, capital raising

A firm wishes to raise $100 million now. The firm's current market value of equity is $300m and the market price per share is $5. They estimate that they'll be able to issue shares in a rights issue at a subscription price of $4. All answers are rounded to 6 decimal places. Ignore the time value of money and assume that all shareholders exercise their rights. Which of the following statements is NOT correct?

Question 789 rights issue, capital raising

A firm wishes to raise $30 million now. The firm's current market value of equity is $60m and the market price per share is $20. They estimate that they'll be able to issue shares in a rights issue at a subscription price of $15. Ignore the time value of money and assume that all shareholders exercise their rights. Which of the following statements is NOT correct?

Question 803 capital raising, rights issue, initial public offering, on market repurchase, no explanation

Which one of the following capital raisings or payouts involve the sale of shares to existing shareholders only?

Question 1010 lemons problem, asymmetric information, adverse selection, fungible

The ‘Lemons Problem’ is likely to more adversely affect the desirability of which type of investment?

Question 1044 leverage, capital structure, beta

A levered firm has only 2 assets on its balance sheet with the below market values and CAPM betas. The risk free rate is 3% pa and the market risk premium is 5% pa. Assume that the CAPM is correct and all assets are fairly priced.

Balance Sheet Market Values and Betas
Balance sheet item	Market value ($m)	Beta
Cash asset	0.5	0
Truck assets	0.5	2
Loan liabilities	0.25	0.1
Equity funding	?	?

Which of the following statements is NOT correct?

Question 1045 payout policy, leverage, capital structure, beta

Balance Sheet Market Values and Betas
Balance sheet item	Market value ($m)	Beta
Cash asset	0.5	0
Truck assets	0.5	2
Loan liabilities	0.25	0.1
Equity funding	?	?

The firm then pays out all of its cash as a dividend. Assume that the beta and yield on the loan liability remain unchanged. Ignore taxes, transaction costs, signalling, information asymmetries and other frictions.

Which of the following statements is NOT correct? This event led to a:

Question 1046 leverage, capital structure

Balance Sheet Market Values and Betas
Balance sheet item	Market value ($m)	Beta
Cash asset	0.5	0
Truck assets	0.5	2
Loan liabilities	0.25	0.1
Equity funding	?	?

The firm then pays off (retires) all of its loan liabilities using its cash. Ignore interest tax shields.

Which of the following statements is NOT correct? All answers are given to 6 decimal places. This event led to a:

Question 427 takeover

Question 428 takeover

Question 429 takeover

Question 420 takeover

Acquirer firm plans to launch a takeover of Target firm. The deal is expected to create a present value of synergies totaling $105 million. A cash offer will be made that pays the fair price for the target's shares plus 75% of the total synergy value. The cash will be paid out of the firm's cash holdings, no new debt or equity will be raised.

Firms Involved in the Takeover
	Acquirer	Target
Assets ($m)	6,000	700
Debt ($m)	4,800	400
Share price ($)	40	20
Number of shares (m)	30	15

Ignore transaction costs and fees. Assume that the firms' debt and equity are fairly priced, and that each firms' debts' risk, yield and values remain constant. The acquisition is planned to occur immediately, so ignore the time value of money.