Question

The recognition that dividends are dependent on earnings, so a reliable dividend forecast is based on an underlying forecast of the firm's future sales, costs and capital requirements, has led to an alternative stock valuation approach, known as the free cash flow valuation model. The market value of a firm is equal to the present value of its expected future free cash flows:

Free cash flows are generally forecasted for 5 to 10 years, after which it is assumed that the final forecasted free cash flow will grow at some long-run constant rate. Once the firm reaches its horizon date, when cash flows begin to grow at a constant rate, the equation to calculate the continuing value of the firm at that date is:

Discount the free cash flows back at the firm's weighted average cost of capital to arrive at the value of the firm today. Once the value of the firm is calculated, the market value of debt and preferred are subtracted to arrive at the market value of equity. The market value of equity is divided by the number of common shares outstanding to estimate the firm's intrinsic per-share value.

We present 2 examples of the free cash flow valuation model. In the first problem, we assume that the firm is a mature company so its free cash flows grow at a constant rate. In the second problem, we assume that the firm has a period of nonconstant growth.

Quantitative Problem 1: Assume today is December 31, 2017. Barrington Industries expects that its 2018 after-tax operating income [EBIT(1 – T)] will be $410 million and its 2018 depreciation expense will be $60 million. Barrington's 2018 gross capital expenditures are expected to be $100 million and the change in its net operating working capital for 2017 will be $20 million. The firm's free cash flow is expected to grow at a constant rate of 6.5% annually. Assume that its free cash flow occurs at the end of each year. The firm's weighted average cost of capital is 8%; the market value of the company's debt is $2.05 billion; and the company has 170 million shares of common stock outstanding. The firm has no preferred stock on its balance sheet and has no plans to use it for future capital budgeting projects. Using the free cash flow valuation model, what should be the company's stock price today (December 31, 2017)? Do not round intermediate calculations. Round your answer to the nearest cent.

$ per share

Quantitative Problem 2: Hadley Inc. forecasts the year-end free cash flows (in millions) shown below. Year 1 2 3 4 5 FCF -$22.89 $37 $43.6 $52.3 $57 The weighted average cost of capital is 9%, and the FCFs are expected to continue growing at a 4% rate after Year 5. The firm has $25 million of market-value debt, but it has no preferred stock or any other outstanding claims. There are 18 million shares outstanding. What is the value of the stock price today (Year 0)? Do not round intermediate calculations. Round your answer to the nearest cent.

$ per share

According to the valuation models developed in this chapter, the value that an investor assigns to a share of stock is dependent on the length of time the investor plans to hold the stock.

The statement above is -Select- .

Conclusions Analysts use both the discounted dividend model and the free cash flow valuation model when valuing mature, dividend-paying firms; and they generally use the corporate model when valuing divisions and firms that do not pay dividends. In principle, we should find the same intrinsic value using either model, but differences are often observed. Even if a company is paying steady dividends, much can be learned from the corporate model; so analysts today use it for all types of valuations. The process of projecting future financial statements can reveal a great deal about a company's operations and financing needs. Also, such an analysis can provide insights into actions that might be taken to increase the company's value; and for this reason, it is integral to the planning and forecasting process.

Answer 1

Q1. $90.88

Q2. $50.30

Step-by-step explanation

Quantitative Problem 1:

What is the value of the stock price today (Year 0)?

Using the Corporate Model :

(i) Determine the expected next year's free cash flow

FCF 2014= EBIT*(1- tax rate) + Depreciation exp. - Capital expenditures- Net Working Capital

= $410+60-100-20

=$350 million

.

(ii) To determine the value of the firm today, discount the free cash flows back at the firm's weighted average cost of capital

V0= FCF1/ (WACC- g)

= $350/ ( 0.08-0.065)

=$17,500

.

(iii) Determine the market value of equity by subtracting the value of debt

=$17,500 million - 2 050 million

=$15,450 million

.

(iv) Divide the equity value by the number of common shares outstanding to estimate the firm's intrinsic per-share value.

=$15,450 million / 170 million shares

=$90.88

Quantitative Problem 2:

What should be the company's stock price today (December 31, 2013)?

Using the Corporate Model :

.

(i) To determine the value of the firm today, discount the free cash flows back at the firm's weighted average cost of capital

Value of the firm = FCF1/ (1+WACC) .....FCF5/ ( 1+WACC)^n plus the continuing value (FCF6/ ( WACC-g) / (1-WACC)^n

PV of the FCF = -22891.090000/ 1.09 + 37000000/ 1.09^2 + 43600000/ 1.09^3+ 52300000/1.09^4+ 57000000/ 1.09^5

= $15,99,06,087.04

Continuation / Terminal value =FCF6/( WACC-g)

= 57 000 000* (1.04)/ ( 0.09-0.04)

=1,18,56,00,000

PV of the continuation value (Terminal value)

=1,18,56,00,000 / 1.09^5

= 77,05,58,651.59

Value of the firm = $15,99,06,087.04 + 77,05,58,651.59

= $93,04,64,738.64

.

(ii) Determine the market value of equity by subtracting the value of debt

= $93,04,64,738.64 - 25 000 000

=$90,54,64,738.64

.

(iii) Divide the equity value by the number of common shares outstanding to estimate the firm's intrinsic per-share value.

=$90,54,64,738.63 / 18 000 000 shares

=$50.30