Chapter 7: Merger and Acquisition Cash Flow Valuation Basics

Answers to End of Chapter Discussion Questions

7.1 What is the significance of the weighted average cost of capital? How is it calculated? Do the weights reflect the firm’s actual or target debt to total capital ratio? Why?

Answer: The weighted average cost of capital (WACC) is a broader measure than the cost of equity and represents the return a firm must earn in order to induce investors to buy its stock and bonds. The WACC is calculated using a weighted average of the firm’s cost of equity and cost of debt. The weights associated with the cost of equity and debt, reflect the firm’s target capital structure or capitalization. These are targets in the sense that they represent the capital structure the firm hopes to achieve and sustain in the future. It is important to remember that these are targets and not the current actual values. The actual market value of equity and debt as a percent of total capitalization may differ from the targets. Market values rather than book values are used, because WACC measures the cost of issuing debt and equity securities at current market prices. Such securities are issued at market and not book value.

7.2 What does a firm’s ß measure? What is the difference between an unlevered and levered ß? Why is this distinction significant?

Answer: A beta coefficient () is a measure of nondiversifiable risk or the extent to which a firm’s (or asset’s) return changes due to a change in the market’s return. It is a measure of the risk of a stock’s financial returns, as compared to the risk of the financial returns to the general stock market. In the absence of debt,  measures the volatility of a firm’s financial return to changes in the general market’s overall financial return. Such a measure of volatility or risk is called an unlevered  and is denoted as u. Increasing leverage will raise the level of uncertainty associated with shareholder returns and increase the value of
. However, this will be offset to some extent by the tax deductibility of interest, which reduces shareholder risk by increasing after-tax cash flow available for shareholders. A beta reflecting the effects of both the increased volatility of earnings and the tax-shelter effects of leverage is called a leveraged or levered l.

7.3 Under what circumstances is it important to adjust the Capital Asset Pricing Model for firm size? Why?

Answer: Small firms tend to be subject to higher default risk and are often less liquid than larger firms. Studies show that the size of a firm is a good proxy for such factors. Since the CAPM reflects only non-diversifiable or market-related risk, it should be adjusted to reflect these factors.

7.4 What are the primary differences between FCFE and FCFF?

Answer: Free cash flow to the firm represents cash available to satisfy all investors holding claims against the firm’s resources.
In the FCFF formulation, there is no effort to adjust for payments of interest or preferred dividends, because this measure of cash flow is calculated before any consideration is given to how expenditures will be financed. Under this definition, only cash flow from operating and investment activities, but not financing activities, is included. The tax rate refers to the firm’s marginal tax rate. Depreciation expense used in all the formulae employed in this book is assumed to include all amortization expense. Free cash flow to equity investors is the cash flow remaining for paying dividends to common equity investors or for reinvesting in the firm after the firm satisfies all obligations. These obligations include debt payments, capital expenditures, changes in net working capital, and preferred dividend payments.

7.5 Explain the conditions under which it makes most sense to use the zero growth and constant growth DCF models. Be specific.

Answer: While often overly simplistic, the zero-growth model may