ch9

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

1. The free cash flow statement is prepared based on the firm’s GAAP statement of cash flows. This is the suggested approach to use because:

1. balance sheets prepared under GAAP require the use of accrual accounting
2. it is time-consuming, although possible, to reproduce the cash flow statements found in most annual reports from the accompanying balance sheets
3. it is simpler to rearrange the items from the GAAP cash flow statement than to re-create a cash flow statement from scratch
4. published balance sheets generally provide much more detail than is necessary to create an accurate cash flows statement

1. When preparing a free cash flow statement, an item such as interest expense may require adjustment. Interest expense will:

a.   be adjusted by moving it from free cash flow to capital cash flow

b.   be adjusted by moving it from free cash flow to nonoperating cash flow

c.   not be adjusted as it is already a component of free cash flow

d.   be adjusted by netting it against interest income and showing the result as a component of free cash flow

1. When preparing a free cash flow statement, the income tax effect from an item such as interest expense must be considered. The income tax expense related to interest expense will:

a.   not be adjusted as income tax expense is considered an item of free cash flow

b.   will be shown as a capital cash flow adjustment

c.   will be shown as a nonoperating cash flow adjustment

d.   will be added to interest expense and the new total shown as a nonoperating cash flow adjustment

1. In converting the GAAP cash flow statement to a free cash flow statement, the analyst must:

a.   remove the free cash flow from any cash flows related to nonoperating assets

b.   remove the free cash flow between the firm and any capital claimants

c.   record any free cash flow equivalents

d.         All of the answers above are correct

1. The adjustments made to convert a GAAP cash flow statement to a free cash flow statement can be grouped into various categories. An adjustment made for the income tax effect of interest income the firm received can be placed in the category of:

a.   free cash flow equivalents

b.   interest expense and related amounts

c.   nonoperating cash flows

d.   employee stock options

1. Distributions from a joint venture:

a.   is a component of free cash flow on the free cash flow statement

b.   will be moved from free cash flow to capital cash flow

c.   will be moved from free cash flow to nonoperating cash flow

d.   will be excluded from the free cash flow statement as the distributions apply to an entity outside of the firm itself

1. The sale or maturity of an available-for-sale investment is shown on the free cash flow statement as a:

a.   free cash flow item

b.   nonoperating cash flow item

c.   capital cash flow item

d.   capital cash flow item, net of the income tax effect on the cash flow from the investment itself

1. Minority interest is the capital that a firm obtains from minority shareholders in consolidated subsidiaries. The change in the firm’s minority interest:

a.   is reclassified to the capital cash flow section because it relates to how the firm is financed, not to its core operations

b.   is reclassified to the nonoperating cash flow section because it relates to other investments of the firm, not to its core operations

c.   is not reclassified on the free cash flow statement

d.   is not shown on the free cash flow statement as it relates to activities outside of the firm itself

1. When an analyst preparing a free cash flow statement encounters an unusual transaction, the best course of action is to:

a.   determine how the transaction is treated under GAAP

b.   determine how it should be treated in the free cash flow statement

c.   adjust the transaction from GAAP to free cash flow

d.   All of the above answers are correct.

1. In a free cash flow statement, the amortization of bond discount is:

a.   not adjusted since it is a component of free cash flow

b.   adjusted by moving it from the free cash flow section to the capital cash flow section of the statement; however, the after-tax interest will remain a component of free cash flow

c.   adjusted by moving it from the free cash flow section to the nonoperating cash flow section of the statement

d.   adjusted by moving it from the free cash flow section to the capital cash flow section of the statement along with the after-tax interest

1. A firm has long-term construction projects. Under GAAP it may:

a.   defer the entire amount of its interest payments until the completion of the construction projects

b.   only expense a portion of its interest payments

c.   choose to expense or capitalize a portion of its interest payments

d.   capitalize a portion of its interest payments and charge the portion to a fixed asset account rather than to interest expense

The amount of interest that a firm with long-term construction projects may capitalize depends on:

a.   if the capitalized interest is considered a free or capital cash flow on the free cash flow statement

b.   the total accumulated cost of the completed long-term construction projects for the accounting period

c.   the average construction in progress balance during the year times the firm’s average borrowing rate, not to exceed the total interest cost incurred during the period

d.   None of the above answers are correct.