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1. The free cash flow model values the free cash flows stream of a firm. The value of other nonequity components is estimated by:

a.   discounting a forecast of the firm’s expected free cash flow for the nonequity components

b.   adding the value of core operations and subtracting the value of debt and other capital claims

c.   direct observation of market values or estimating fair values in other ways

d.   adding the value of debt and other capital claims minus the value of core operations

1. To be able to use historical ratios for forecasting, they must be calculated in exactly the same way as the ratios used to forecast free cash flow. The appropriate historical ratios cannot be calculated directly from GAAP financial statements because:

a.   GAAP requires the use of accrual accounting

b.   these ratios include the effects of transactions that are not related to core operations

c.   these ratios do not include the effects of transactions related to core operations

d.   GAAP separates free cash flows from other cash flows

1. The GAAP income statement and statement of cash flows differ from the free cash flow statement:

a.   because GAAP categorizes cash flows in a different way than does the free cash flow statement

b.   because the net cash flow from the GAAP cash flow statement is different than the net cash flow from the free cash flow statement

c.   GAAP does not report in the income statement or statement of cash flows certain noncash transactions that are included in the free cash flow statement

d.   Answers a and c are both correct.

1. One difference between GAAP financial statements and the free cash flow statement is that the free cash flow statement includes free cash flow equivalents. These are transactions that:

1. have a component relating to the firm’s operations not found in the GAAP financial statements
2. have one component relating to the firm’s operations and a second relating to another element of the economic balance sheet such as a component of capital
3. are essentially only one transaction that is shown on the free cash flow statement
4. None of the above answers are correct.

1. To create a free cash flow statement from GAAP information, the analyst should:

1. reorganize the line items in the combined GAAP income and cash flow statements into the categories of free cash flow, nonoperating cash flow, and capital cash flow
2. discount the line items in the combined GAAP income and cash flow statements to their present values
3. convert GAAP cash flow from operations to free cash flow by adjusting the components of debt and other capital elements out of the GAAP cash flow from operations
4. convert GAAP cash flow from investing activities to free cash flow by adjusting the cash flows to their net present value based on the current cost of capital for the firm

1. On a free cash flow statement, sales, cost of sales, and selling, general, and administrative expenses:

a.   all relate to the firm’s core operations, so these items are classified as part of free cash flow

b.   may not be identical to the items as presented on a GAAP financial statement

c.   are considered free cash flow equivalents

d.   must be presented using the GAAP standard of cash-basis accounting

1. If a free cash flow equivalent such as the acquisition of a machine in exchange for debt is not shown in a free cash flow statement:

a.   the capital expenditure will be understated by the amount that the machine was paid for with debt

b.   the cash balance from core operations will be understated and the analyst would have an erroneous forecast

c.   the addback for depreciation expense will be unaffected

d.   the income tax expense will be unaffected

1. To construct a free cash flow statement, the analyst must:

1. only use and rely on the GAAP statement of cash flows when preparing the free cash flow statement
2. determine how an item was treated under GAAP and how it should be treated in the free cash flow statement
3. realize that in reorganizing and adjusting 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 statement
4. disregard the GAAP cash flow categories of operating, investing, and financing when preparing the free cash flow statement