Homework answers / question archive / Explain the concept of "free" cash flows

Explain the concept of "free" cash flows

Finance

Share With

1. Explain the concept of "free" cash flows. What makes them "free"?
   a. Free cash flows emanate from the balance sheet, after projecting how all of the assets and liabilities will generate future cash flows.
   b. Free cash flows are cash flows that are generated by the operations of the firm and, after making necessary investments in future operating and investing activities, are unencumbered and available to be distributed to shareholders and debtholders.
   c. Free cash flows are cash flows already owned by the firm, and so the firm does not have to incur costs to raise these cash flows.
   d. Free cash flows are simply measured as cash flows from operating activities plus or minus cash flows from investing activities on the statement of cash flows.
2. The theory supporting free cash flow-based valuation is that
   a. free cash flows into the firm are value-relevant to common equity shareholders because they represent the cash flows that will be available to pay future dividends to the equity shareholders.
   b. free cash flows are equivalent to the difference between the comprehensive income and the required income ("normal earnings") of the firm.
   c. cash is cash. Cash is king.
   d. free cash flows represent firm performance and how well the firm is generating value for shareholders each year.
3. How do free cash flows available for debt and equity stakeholders differ from free cash flows available for common equity shareholders?
   a. Free cash flows available for debt and equity stakeholders are always larger than free cash flows available for common equity shareholders in every year.
   b. Free cash flows available for debt and equity stakeholders include cash flows that are available to repay debtholders, whereas free cash flows available for common equity shareholders do not.
   c. Free cash flows available for debt and equity stakeholders subtract cash flows paid for interest expense (after tax), whereas free cash flows available for common equity shareholders add cash paid for interest expense.
   d. All of these answer choices are correct.
4. Describe which types of cash flows are not free for common equity shareholders?
   a. Cash flows available to pay dividends
   b. Cash flows required to repay debt principal and cash flows required to pay interest expense
   c. Cash flows received from issuing preferred stock
   d. Cash flows received from issuing debt
5. The free cash flow-based valuation approach cannot be used for firms that generate negative cash flows.
   a. True
   b. False
6. Conceptually, why should you expect valuation based on dividends and valuation based on the free cash flows for common equity shareholders to yield identical value estimates?
   a. Both approaches use the same data and forecasts for the same company.
   b. Both approaches should use the same discount rates and long-term growth rates.
   c. The free cash flows available for common equity shareholders will be the future cash flows the firm has available to pay future dividends and repurchase shares.
   d. All of these answer choices are correct
7. If the firm borrows cash by issuing debt, how does that transaction affect free cash flows for common equity shareholders?
   a. In that period, borrowing increases cash flows available for equity shareholders but reduces the available cash flows in future periods when the debt must be repaid.
   b. Borrowing should increase the firm's leverage and risk, and therefore the expected return for equity shareholders.
   c. Borrowing affects cash flows for debtholders but not equity holders.
   d. Borrowing creates additional cash flows from tax savings from interest and principal payments.
8. Suppose you are seeking to value a stream of expected future cash flows that will be used to pay all future debt and equity holder financing claims. What is the appropriate discount rate?
   a. 12.0%
   b. The weighted-average cost of capital
   c. 6.0%
   d. The required rate of return on equity, according to the CAPM
9. Suppose you are valuing a healthy, growing, profitable firm and you project that the firm will generate negative free cash flows for equity shareholders in each of the next five years. Explain how a free-cash-flows approach can produce positive valuations of a firm that is expected to generate negative free cash flows over the next five years.
   a. You can use the free cash flows-based valuation approach in this case and determine a positive value of the firm as long as the long-run cash flows (beyond the five-year forecast horizon) will be positive.
   b. You cannot use the free cash flows-based valuation approach in this case because you will get a negative value.
   c. Negative cash flows are a sign of distress; the free cash flows-based valuation approach should not be used for firms in distress.
   d. You can certainly use the free cash flows-based valuation approach, but you will get a negative value.
10. Describe circumstances when free cash flows to equity shareholders and free cash flows to all debt and equity stakeholders will be identical.
    a. When the firm is only financed by common shareholders' equity, with no outstanding debt or preferred stock
    b. During the start-up phase of life, when free cash flows for both debt and equity will typically be negative
    c. When the cost of debt capital is exactly equal to the required rate of return on equity, according to the CAPM
    d. When the capital structure is exactly balanced, with 50% debt financing and 50% equity financing