4. Free cash flow and financial statements

The primary objective of the corporate management team is to maximize shareholder wealth. The companys board of directors and the shareholders evaluate and review managerial actions based on the growth in the value of the firm.

Based on your understanding of what determines a firms value, review the following:

	What does the value of a firm depend on?
Option A	The ability to generate cash flow that is available to distribute to the companys investors, including creditors and stockholders
Option B	The ability to generate cash flow that is available to distribute to the companys stockholders only

Which of the options is most accurate?

Option B

Option A

When determining the value of a firm, which of the following statements is true?

Investors are risk neutral. Other things being equal, they prefer to pay more for stocks that are less risky and have uncertain cash flows.

Investors are risk averse. Other things being equal, they prefer to pay more for stocks that are less risky and that have relatively more certain cash flows than other stocks.

Investors love risk. Other things being equal, they prefer to pay more for stocks that are riskier and have uncertain cash flows.

Managers strive to increase the value of a firm. An increase in the intrinsic value of the firms stocks is a good measure of the increase in the value of the firm. Intrinsic value of a firms stock price is determined by calculating the present values of its free cash flows (FCF) discounted at a rate called the weighted average cost of capital (WACC).

Tyler is a team member in Corporate Finance at a digital-content production company. He is required to forecast the free cash flows that the company will be able to generate in the next three years. Tyler takes into account only the following equation in his calculation:

FCF

=

Sales Revenues Operating Costs Operating Taxes

Will his calculation be an appropriate estimate of the FCF?

Yes

No

Why or why not? Check all that apply.

Because his calculation fails to include the costs of the firms interest and dividend payments

Because his calculation fails to recognize the increase in sales revenues

Because his calculation fails to include the value of the debt that the firm carries on its balance sheet

Because his calculation fails to include the increase in the working capital required to grow sales