Question

Which of the following statements is (are) most likely TRUE:

I. If interest expense increases, FCFF will increase, but FCFE stay the same (Note: Assume taxes >0)

II. In theory, FCF models should provide the same estimate of intrinsic value as DDM models, but in practice, the estimate of intrinsic value can vary between the two models (sometimes substantially!)

III. If management plans to change the company’s depreciation schedule (e.g. from straight line to accelerated), CFO will not change because depreciation is a non-cash charge

a) I

b) II

c) III

d) I, II, III

e) None of the statements

Answer 1

b) Only II is true

Reason for I - The logic is straightforward. The interest payments are payments to the debt holders. So, it will impact only FCFE because FCFE is calculated by subtracting the interest payments from the FCFF. If some debt (principal) is also repaid, then that is further reduced from the FCFF because the total funds left for the equity holders will be reduced. If some debt is issued then that is added as there is not more cash flow available for distribution to the equity holders. There will be no impact on FCFF.

Reason for II - The DDM is very similar to the FCF valuation method; the difference is that DDM focuses on dividends. Just like the FCF method, future dividends are worth less because of the time value of money. Investors can use the DDM to price stocks based on the sum of future income flows by the risk-adjusted required rate of return.

Reason for III - The use of depreciation can reduce taxes that can ultimately help to increase net income. Net income is then used as a starting point in calculating a company's operating cash flow. Operating cash flow starts with net income, then adds depreciation/amortization, net change in operating working capital, and other operating cash flow adjustments. The result is a higher amount of cash on the cash flow statement because depreciation is added back into the operating cash flow.