Question

A company reported the following numbers for the most recent fiscal year:

Revenues	$3,000
EBITDA	$650
DA (Depreciation)	$150
EBIT	$500
- Interest Expenses	$50
Taxable Income	$450
Taxes	$135
Net Income	$315
Payout	$157.5

During the year, the company reported capital expenditures of $250 and an increase in net working capital of $40. The tax rate is 30%. Assume that we know the following:
• The company’s FCF will grow at 8% per year for the next five years.
• The company’s current cost of capital is 12%, which will stay at that level for the next 5 years.
• The company maintains a stable dividend policy, i.e., its payout ratio stays the same for all future years.
• At the end of year 5, the company is expected to become a mature business, facing a cost of capital of 8% (mature company levels). It will also maintain a constant debt-to-equity ratio (sustainable growth).
• At the end of year 5, the company is expected to have an ROE of 4%, and an ROA of 3%.

Assume also for simplicity that all cash flows are nominal and risky, and they occur at the end of the periods.

What is the FCF at year 3?                            [ Select ]                       ["$265", "$314", "$245", "None of the above", "$277"]      

Estimate the company’s terminal value at the end of year 5 from future FCFs.                            [ Select ]                       ["None of the above", "3,161", "2,990", "5,284", "4,861"]      

Answer 1

Solution:

FCF at Year 3:

Growth rate = 8%

FCF at year 3 = FCF at year 0 * [ 1+ 8%]³

= 210 * 1.08³

=$265

Terminal Value at Year 5:

Terminal Value =[ FCF at year 5 ( 1+growth) ] / (Cost of capital - growth)

Sustainable Growth rate = ROE at year 5 * Retention ratio / [ 1- ( ROE at year 5 * Retention ratio ) ]

retention ratio = 1- Dividend payout ratio

Dividend payout ratio = Dividend payout / Net income = 157.5/315 = 0.5

Therefore, Retention ratio = 1-0.5 = 0.5

ROE = 4%

Sustainable Growth rate = 4% * 0.5 / [ 1- (4%*0.5) ]

= 2% / 0.98% = 2.040816%

Cost of capital = 8% (given)

FCF at year 5 = FCF at year 0 * [ 1+ 8%]⁵ = 308.59

Applying the values,

Terminal Value = [308.59 ( 1+2.040816%) ] / (8% - 2.040816%)

= 314.88775 / 5.959184%

= $5284