FCFE Flashcards
how to calculate proportion of cash to stockholders? what values can the ratio assume?
(DIV+repurchases)/FCFE. it is eaither close to 1 meaning the firm distributes all FCFE, lower than 1 meaning that the firm accumulates cash and cash equivalents, or greater than 1 if the firm is issuing stock or drawing from the current cash balance to distribute.
what are the implicit assumptions we make when we use FCFE discounting instead of DDM?
we assume the firm pays out all of FCFE. this means that cash (outside of required cash for operations) is not built up and that growth is only driven by operating assets as the firm does not invest anything in financial ones.
why usually FCFE is not entirely paid out?
Desire for stability
Firms are generally reluctant to change dividends and dividends are considered “sticky”, because
the variability in dividends is significantly lower than the variability in earnings or cash flows
2. Signaling prerogatives
Firms often use dividends as signals of future prospects, with increases in dividends being
viewed as positive signals and decreases as negative signals. The use of dividends as signals may
lead to differences between dividends and FCFE
3. Future investment needs
Afirmmight hold back on paying its entire FCFE as dividends if it expects substantial increases in
CAPEX needs. Since issuing securities is expensive (transaction costs, …), it may choose to keep
the excess cash to finance these future needs
4. Tax factors
If dividends are taxed at higher tax rate than capital gains, a firm may choose to retain
the excess cash and pay out much less in dividends than it has available
5. Managerial self-interest
The managers of a firm may gain by retaining cash rather than paying it out as a dividend
how is g computed in a FCFE model?
equity reinvestment rate*non-cash ROE
how is non-cash ROE computed?
(NI-after-tax financial income)/(equity-cash&financial assets)
how is equity reinvestment rate calculated?
(net CAPEX + changes in NWC - net increase in debt financing)/NI
what are limitations of the FCFE model?
sensitive to g assumptions.
for which firms does FCFE model work best?
(constant growth) if the firm’s growing at a stable rate lower than that of GDP. in general it is good to compute equity value for firms that are paying out unsustainably low/high amounts of their FCFE as dividends/repurchases.
how does the relationship between Ke and ROE affect total value?
if ROE<Ke, reinvestments destroy value. the would be better off with equity reinvested=0.
if ROE=Ke reinvestments do not affect value, the firm only grows in size but the PV increase given by g is perfectly offset by the decrease in FCFE given by distributons.
If ROE>Ke reinvestments generate value and the firm grows both in size and value by reinvesting.
