Question

Your employer, a mid-sized human resources management company, is considering expansion into related fields, including the acquisition of Temp Force Company, an employment agency that supplies word processor operators and computer programmers to businesses with temporary heavy workloads. Your employer is also considering the purchase of Biggerstaff & McDonald (B&M), a privately held company owned by two friends, each with 5 million shares of stock. B&M currently has free cash flow of $24 million, which is expected to grow at a constant rate of 5%. B&M’s financial statements report short-term investments of $100 million, debt of $200 million, and preferred stock of $50 million. B&M’s weighted average cost of capital (WACC) is 11%. Answer the following questions.

1. What is free cash flow (FCF)? What is the weighted average cost of capital? What is the free cash flow valuation model?

2. Suppose the free cash flow at Time 1 is expected to grow at a constant rate of gL forever. If gL < WACC , what is a formula for the present value of expected free cash flows when discounted at the WACC? If the most recent free cash flow is expected to grow at a constant rate of gL forever (and gL < WACC ), what is a formula for the present value of expected free cash flows when discounted at the WACC? gL= long term growth rate

I don’t mind if the answers are the same as other answers for similar questions. I just need some help understanding so a breakdown of the work would be helpful. Thank you in advance.

Answer 1

Solution 1) a) Free cash flow (FCF) is the cash flow available for distribution to all of a company’s investors after including the capital expenditures. Free Cash Flows are of two types on the basis of the perspective, i.e., Free Cash Flow to Firm and Free Cash Flow to Equity.

Solution 1) b) The weighted average cost of capital (WACC) is the overall rate of return required by all the capital providers or investors of the company, i.e, debt holders and equity shareholders. WACC is calculated as follows:

WACC = Wd*Kd*(1 -Tax%) + We*Ke + Wpe*Kpe

Where Wd = Weight of the debt

Kd = Cost of the debt

We = Weight of the equity

Ke = Cost of the equity

Wpe = Weight of the preferred equity

Kpe = Cost of the preferred equity

Solution 1) c) Free Cash Flow Valuation Model calculates the value of the firm or equity as the present values of the free cash flows. discounted at the Weighted Average Cost of Capital (WACC).

Solution 2) a) If the free cash flow at Time 1 (FCF1) is expected to grow at a constant rate of gL forever, then, it will form perpetuity.

Thus, according to the Gordon Growth Model, the present value is calculated as:

Value = FCFF1/(WACC - gL)

Where gL = long term growth rate

Solution 2) b) If the most recent free cash flow (FCF0) is expected to grow at a constant rate of gL forever, then, it will form perpetuity.

Thus, according to the Gordon Growth Model, the present value is calculated as:

Value = FCFF0*(1 + gL)/(WACC - gL)

Where gL = long term growth rate

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