What is constant and non constant growth in free cash flow valuation model? (Please include an...

What is constant and non constant growth in free cash flow valuation model? (Please include an example question and formulas used)

Solutions

Expert Solution

Constant growth involves free cash flows fixed growth of free cash which is discounted at (Required rate of return - growth) to provide enterprise value of the firm.
Formula : Value of Firm = Free Cash Flow *(1+ growth)/((Required rate of return - growth)
Example
The free cash flow of a firm in current year = 100 million
Required rate = 15%
The growth of Free cash fkow from next year till perpetuity = 5%
What is the value of the firm ?
Answer: The value of firm = 100*(1+15%)/(15% - 5%) = 115/0.1 = 1150 million.

Non Constant growth involves no growth or varying growth over a period which has to be discounted by the required rate to arrive at the valuation of the firm.

Formula : Value of Firm = Free cash flow *(1+growth 1)/(1+Rate) + Free cash flow *(1+growth 1)*(1+growth 2)/(1+Rate)² + Free cash flow *(1+growth 1)³/(1+Rate)³ + ....... + Free cash flow *(1+growth 1)ⁿ/(1+Rate)ⁿ
Example
For 3 years A firm will have growth of 25%, 20%,15% respectively in its free cash flow. With required rate of 10% what will be value of firm Free Cash Flow = 10million

Solution
Value of Firm = 10*(1+25%)/(1+10%) + 10*(1+25%)*(1+20%)/(1+10%)² + 10*(1+25%)*(1+20%)(1+15%)/(1+10%)³ = 36.16

jeff jeffy answered 1 year ago

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