DR for FCFE ?

CFA Level II Equities
#1

I understand the purpose of including the DR ratio in the FCFE estimation, as it serves to simplify and account for the net borrowings impact on FCFE. I’m struggling with a few things, however, and need some help grasping the full concept. Assistance would be greatly appreciated.

1.) What if debt repayment exceeds new debt borrowing…would you use 0 for DR, or how would that be reflected in FCFE ?? I would tend to think this a more likely scenario then companies regularly issuing new debt and thus there essentially being an increase in FCFE, but the book spends most time addressing issuance > repayment. Would there also need to be a deduction from FCFE to account for the repayment of debt ?

2.) When dealing with FCFF, the financing of FCInv and WCInv is not necessarily considered/adjusted for like FCFE bc we’re dealing with a total firm cash flow basis (equity and debt holders), correct ? And therefore these just represent deductions from total cash flow without consideration of how they are financed ?

3.) Seems odd that we’re essentially only backing out of FCFE the amount of incremental FCInv and WCInv that is paid by equity holders (1-DR), and leaving the debt financed portion in FCFE. Seems like if say 40% is financed with debt, that we’dd subtract that amount to arrive at FCFE. But i guess since we are estiamting FCFE and equity investors are financing 60%, then that 60% is no longer available to equity holders so that’s why you back it out and not the 40%. Is any of that interpretation correct ?

4.) In some examples, the book says interest expense will grows annually. If the company has a certain amount of debt with a certain annual interest expense (cpn payments) then how is interest growing ?? Is this to account for new debt issuances and total increase in interest expense as a result ??

5.) Lastly, i know this is just math, but how does the actual capital structure differ at times from the target structure used in the WACC estimate that is ultimately used to find the PV. Seems like if you use target weights, then the actual capital strcuture implied by the present value would equal the target amounts, no?

Thank you, anyone, for your patience and helping me with these!!!

#2

I think when we have to forecast FCFE we use DR in it and it represents the target debt to asset ratio which implies that 1. It can’t be greater than 1 as if 100% the asset is financed by debt it would be 1. 2. Since we are using target debt to asset ratio, we assume that there would be no net borrowings additional available for equity investors and for this reason the formula is FCFE = NI - (1-DR)(FCINV) - (1-DR)(WCInc).

Regarding interest expense may be a growing firm in some cases need to issue new debt and that is why it increments in interest expense.

I think when market values change for debt and equity, weights change and this could result in firm deviating from its target capital structure. The company then tries to achieve its target capital structure as it thinks that it is the optimum structure.

#3

Thanks Mohammad !

Any other insight to accompany that???

#4

Bmiller - the two formulae you are talking about are kind of intertwined. do not confuse the two.

FCFE = NI - (1-DR)(FCINV) - (1-DR)(WCInc)

If you expanded this out…

FCFE = NI - FCINV - WCInv + DR(FCInv + WCInv)

Compare this with the formula

FCFE = NI - FCInv - WCInv + Net Borrowing

The company is stable, is in a position where whatever it needs to spend on its Fixed Capital Investments and its WC Investments are debt financed to the extent of their DR (Debt Ratio), the rest they generate internally.

So that DR(FCINV + WCINV) comprises the Net Borrowing the company needs.

And DR can never be greater than one.

#5

What about less than 1 ? That’s somewhat rhetorical bc I realize that it’s a percentage but what if repayments exceed issuances, would you not have negative net borrowing ? How wOuld that be reflected DR. You should subtract from FCFE, not add in that case…no?

#6

Meant less than 0 (in first sentence above)

#7

you seem to be missing the point I made in my post. The DR in this method is for a STABLE company. It will have something like a 60/40 or a 70/30 or some such number as the Assets to Liabilities on their balance sheet. Company has existed for a very long time, and typically their requirements would be ONLY for maintenance and regular WC. Not the large amounts of funding required for a startup. so having extremes of 0 or 1 (whatever it may be) IS NOT SOMETHING THAT WOULD BE RIGHT.

Do not know if you are extensively using Schweser for a lot of this stuff… I would definitely recommend for Equity to read the original books. A lot of stuff is better explained there in. Yes, it is wordy, voluminous, but it has a story which makes sense.

#8

Thanks, cpk. Always enjoy and appreciate your answers. I like when you’re un shows up under recent responses. I typically use a combination of both books, referring back to CFAI when i need it…which is often.

Thanks again, all!

#9

Thanks CPK, it was helpful…

#10

From the study material i have. The forecast FCFE = NI – [(1-DR)*(FCInv-Dep)] – [(1-DR)*WCInv].

And then I break it out and get this equation: FCFE = NI + Dep – FCInv - WCInv + DR * (FCInv + WCInv - Dep)

As we all know FCFE = NI + Dep – FCInv - WCInv + Net borrowing.

From what i understand, Net borrowing = DR * (FCInv + WCInv) but here we have another component DR*Depreciation.

I am confused. Can anyone help me?

Thanks in advance!

Sophie

#11

I think this is because we need the Net investment in Fixed Capital? Not sure though…