Question

Bay Properties is considering starting a commercial real estate division. It has prepared the following? four-year forecast of free cash flows for this? division:

	Year 1	Year 2	Year 3	Year 4
Free cash flow	?$152,000	$12,000	$84,000	$211,000

Assume cash flows after year 4 will grow at

4%

per? year, forever. If the cost of capital for this division is

10%?,

what is the continuation value in year 4 for cash flows after year? 4? What is the value today of this? division???

What is the continuation value in year 4 for cash flows after year? 4?

Answer 1

Formula sheet

A	B	C	D	E	F	G	H	I	J
2
3
4		Terminal growth rate (g)	0.04
5		Cost of capital (w)	0.1
6
7
8		Year	Year 1	Year 2	Year 3	Year 4
9		Free cash flow	152000	12000	84000	211000
10
11		Since terminal growth rate starts at year 5, value of terminal cash flow at the end of year 4 can be calculated as follows:
12		Terminal cash flow in year 4	=FCF4*(1+g)/(w-g)
13			=G9*(1+D4)/(D5-D4)	=G9*(1+D4)/(D5-D4)
14
15		Hence continuation value in Year 4 is	=D13
16
17			0	1	2	3	4
18		Free Cash Flow		=D9	=E9	=F9	=G9
19		Terminal value					=D15
20		WACC	=D5
21		Present Value Factor (P/F,i,n)		=1/(1+$D20)^E17	=1/(1+$D20)^F17	=1/(1+$D20)^G17	=1/(1+$D20)^H17
22		Present value of cash flows		=E18*E21	=F18*F21	=G18*G21	=(H18+H19)*H21
23		Present value of cash flows	=SUM(E22:J22)	=SUM(E22:H22)
24
25		Hence the value of the division today is	=D23
26