CFA Level II ExamEquity InvestmentsMedium
A financial analyst is valuing Nova Corp using the Free Cash Flow to Equity (FCFE) model. Nova Corp's current FCFE is $10 million. The company is expected to grow at 15% for the next three years, after which the growth rate is expected to decline linearly over two years to a stable long-term growth rate of 5%. The required rate of return for Nova Corp's equity is 12%. What is the FCFE for year 3?
- A$16.638 million
- B$15.209 million
- C$11.50 million
- D$13.225 million
Show answer & explanationAnswer & explanation
Correct answer: B. $15.209 million
FCFE for year 1 = $10 million * (1 + 0.15) = $11.50 million. FCFE for year 2 = $11.50 million * (1 + 0.15) = $13.225 million. FCFE for year 3 = $13.225 million * (1 + 0.15) = $15.20875 million, which rounds to $15.209 million.
Why the other options are wrong
- A. This value would result from an incorrect calculation or growth rate application.
- C. This is the FCFE for year 1, not year 3.
- D. This is the FCFE for year 2, not year 3.
Free Cash Flow to Equity (FCFE)
The cash flow available to equity holders after all operating expenses and debt obligations have been paid and necessary investments in working capital and fixed capital have been made.
- Represents the cash available for distribution to shareholders.
- Often used in valuation models, especially when dividends are not stable or predictable.
- Calculated as Net Income + Depreciation - Capital Expenditures - Change in Working Capital + Net Borrowing (or similar variations).
Memory trick: Cash Flow grows forward, year by year.