Sd9 Free Cash Flow and Model Analysis

8/11/2019 Sd9 Free Cash Flow and Model Analysis

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CHAPTER 9

FREE CASH FLOW MODEL AND ANALYSIS

LEARNING OBJECTIVES

1. The free cash flow valuation model.

2. The difference between free cash flow and GAAP definitions of cash flow.3. The definition of free cash flow equivalents and why they are included in the free cash flow model.4. How to derive a free cash flow statement from a historical combined GAAP income statement and cash flow

model.

TRUE/FALSE QUESTIONS

1. Because a forecast is forward looking it is often a good !redictor of the future.(moderate, L.O. 1, Section 1, true)

". Although the free cash flow breakdown differs from the GAAP cash flow categories the net cash flow ise#actly the same.(moderate, L.O. 2, Section 2, true)

$. %et cash flow can be defined as the change in cash that occurs over a !eriod for a firm.(moderate, L.O. 2, Section 2, true)

&. 'ertain noncash transactions that are not included in the GAAP income statement but are included in theGAAP statement of cash flows are called free cash flow equivalents.(moderate, L.O. 3, Section 2, false)

(. Adding GAAP cash flow from o!erations and GAAP cash flow from investing is a good starting !oint toderive free cash flow.(difficult, L.O. 3, Section 2, true)

). *hen !re!aring a free cash flow statement any cash flow resulting from an item such as a nono!eratingnet asset must be moved into the free cash flow section of the statement.(moderate, L.O. 4, Section 3, false)

+. Published balance sheets !re!ared under GAAP !rovide sufficient detail to create an accurate cash flowstatement.(difficult, L.O. 4, Section 3, false)

,. -t is not necessary to understand how GAAP treats the firms transactions when !re!aring the free cashflow statement.(moderate, L.O. 4, Section 3, false)

/. 0ree cash flow adustments can be made without a thorough understanding of GAAP since this statement isnot !re!ared under GAAP.(moderate, L.O. 4, Section 3, false)

12. The analyst must know the firms federal and state income ta# rates to determine the amounts of ta# effectson various items in the free cash flow statement.(moderate, L.O. 4, Section 3, true)

11. The analyst double3checks that no items have been missed in the conversion of the GAAP cash flowstatement to the free cash flow statement by confirming that the total net change in cash is the same forboth statements.

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(moderate, L.O. 4, Section 3, true)

1". 4nlike changes in interest !ayable the amorti5ation of bond discount or !remium is a difference betweeninterest e#!ense recogni5ed and cash !aid.(difficult, L.O. 4, Section 3, false)

1$. Any change in the !rinci!al amount of debt during the year that is not e#!lained by issuances orre!ayments is due to amorti5ation.(moderate, L.O. 4, Section 3, true)

1&. -f there is essentially no difference between ca!itali5ed interest for financial re!orting and for ta# there isno ta# effect necessary in making this adustment in the free cash flow statement.(moderate, L.O. 4, Section 3, true)

1(. *hen a firm has long3term construction contracts the amount of interest it may ca!itali5e de!ends on thetotal dollar value of the contracts for the time !eriod.(moderate, L.O. 4, Section 3, false)

MULTIPLE CHOICE QUESTIONS

1). The free cash flow model values the free cash flows stream of a firm. The value of other nonequitycom!onents is estimated by6a. discounting a forecast of the firms e#!ected free cash flow for the nonequity com!onentsb. adding the value of core o!erations and subtracting the value of debt and other ca!ital claimsc. direct observation of market values or estimating fair values in other waysd. adding the value of debt and other ca!ital claims minus the value of core o!erations(moderate, L.O. 1, Section 1, c)

1+. To be able to use historical ratios for forecasting they must be calculated in e#actly the same way as theratios used to forecast free cash flow. The a!!ro!riate historical ratios cannot be calculated directly fromGAAP financial statements because6a. GAAP requires the use of accrual accountingb. these ratios include the effects of transactions that are not related to core o!erations

c. these ratios do not include the effects of transactions related to core o!erationsd. GAAP se!arates free cash flows from other cash flows(moderate, L.O. 1, Section 1, b)

1,. The GAAP income statement and statement of cash flows differ from the free cash flow statement6a. because GAAP categori5es cash flows in a different way than does the free cash flow statementb. because the net cash flow from the GAAP cash flow statement is different than the net cash flow from

the free cash flow statementc. GAAP does not re!ort in the income statement or statement of cash flows certain noncash transactions

that are included in the free cash flow statementd. Answers a and c are both correct.(difficult, L.O. 2, Section 2, d)

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1/. 7ne difference between GAAP financial statements and the free cash flow statement is that the free cashflow statement includes free cash flow equivalents. These are transactions that6a. have a com!onent relating to the firms o!erations not found in the GAAP financial statementsb. have one com!onent relating to the firms o!erations and a second relating to another element of the

economic balance sheet such as a com!onent of ca!italc. are essentially only one transaction that is shown on the free cash flow statementd. %one of the above answers are correct.(moderate, L.O. 3, Section 2, b)

"2. To create a free cash flow statement from GAAP information the analyst should6a. reorgani5e the line items in the combined GAAP income and cash flow statements into the categories of

free cash flow nono!erating cash flow and ca!ital cash flowb. discount the line items in the combined GAAP income and cash flow statements to their !resent valuesc. convert GAAP cash flow from o!erations to free cash flow by adusting the com!onents of debt and

other ca!ital elements out of the GAAP cash flow from o!erationsd. convert GAAP cash flow from investing activities to free cash flow by adusting the cash flows to their

net !resent value based on the current cost of ca!ital for the firm(moderate, L.O. 3, Section 2, a)

"1. 7n a free cash flow statement sales cost of sales and selling general and administrative e#!enses6a. all relate to the firms core o!erations so these items are classified as !art of free cash flowb. may not be identical to the items as !resented on a GAAP financial statementc. are considered free cash flow equivalentsd. must be !resented using the GAAP standard of cash3basis accounting(moderate, L.O. 3, Section 2, a)

"". -f a free cash flow equivalent such as the acquisition of a machine in e#change for debt is not shown in afree cash flow statement6a. the ca!ital e#!enditure will be understated by the amount that the machine was !aid for with debtb. the cash balance from core o!erations will be understated and the analyst would have an erroneous

forecastc. the addback for de!reciation e#!ense will be unaffectedd. the income ta# e#!ense will be unaffected

(moderate, L.O. 3, Section 2, a)

"$. To construct a free cash flow statement the analyst must6a. only use and rely on the GAAP statement of cash flows when !re!aring the free cash flow statementb. determine how an item was treated under GAAP and how it should be treated in the free cash flow

statementc. reali5e that in reorgani5ing and adusting the total cash flow the net cash flow from free cash flow

statement will not equal the net cash flow from the GAAP cash flow statementd. disregard the GAAP cash flow categories of o!erating investing and financing when !re!aring the free

cash flow statement(difficult, L.O. 4, Section 3, b)

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$2. The sale or maturity of an available3for3sale investment is shown on the free cash flow statement as a6a. free cash flow itemb. nono!erating cash flow itemc. ca!ital cash flow itemd. ca!ital cash flow item net of the income ta# effect on the cash flow from the investment itself(moderate, L.O. 4, Section 3, b)

$1. 9inority interest is the ca!ital that a firm obtains from minority shareholders in consolidated subsidiaries.

The change in the firms minority interest6a. is reclassified to the ca!ital cash flow section because it relates to how the firm is financed not to its

core o!erationsb. is reclassified to the nono!erating cash flow section because it relates to other investments of the firm

not to its core o!erationsc. is not reclassified on the free cash flow statementd. is not shown on the free cash flow statement as it relates to activities outside of the firm itself(difficult, L.O. 4, Section 3, a)

$". *hen an analyst !re!aring a free cash flow statement encounters an unusual transaction the best course ofaction is to6a. determine how the transaction is treated under GAAPb. determine how it should be treated in the free cash flow statementc. adust the transaction from GAAP to free cash flowd. All of the above answers are correct.(easy, L.O. 4, Section 3, d)

$$. -n a free cash flow statement the amorti5ation of bond discount is6a. not adusted since it is a com!onent of free cash flowb. adusted by moving it from the free cash flow section to the ca!ital cash flow section of the statement:

however the after3ta# interest will remain a com!onent of free cash flowc. adusted by moving it from the free cash flow section to the nono!erating cash flow section of the

statementd. adusted by moving it from the free cash flow section to the ca!ital cash flow section of the statement

along with the after3ta# interest

(moderate, L.O. 4, Section 3, d)

$&. A firm has long3term construction !roects. 4nder GAAP it may6a. defer the entire amount of its interest !ayments until the com!letion of the construction !roectsb. only e#!ense a !ortion of its interest !aymentsc. choose to e#!ense or ca!itali5e a !ortion of its interest !aymentsd. ca!itali5e a !ortion of its interest !ayments and charge the !ortion to a fi#ed asset account rather than

to interest e#!ense(moderate, L.O. 4, Section 3, d)

$(. The amount of interest that a firm with long3term construction !roects may ca!itali5e de!ends on6a. if the ca!itali5ed interest is considered a free or ca!ital cash flow on the free cash flow statement

b. the total accumulated cost of the com!leted long3term construction !roects for the accounting !eriodc. the average construction in !rogress balance during the year times the firms average borrowing ratenot to e#ceed the total interest cost incurred during the !eriod

d. %one of the above answers are correct.(difficult, L.O. 4, Section 3, c)

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Sd9 Free Cash Flow and Model Analysis

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