Question

Your firm would like to evaluate a proposed new operating division. You have forecasted cash flows for this division for the next five​ years, and have estimated that the cost of capital is

10%.

You would like to estimate a continuation value. You have made the following forecasts for the last year of your​ five-year forecasting horizon​ (in millions of​ dollars):

	Year 5
Revenues	​ $259.5
Operating income	83.8
Net income	54.5
Free cash flows	102.5
Book value of equity	179.0

​Note: Assume that all firms​ (including yours) have no debt.

a. You forecast that future free cash flows after year 5 will grow at

2%

per​ year, forever. Estimate the continuation value in year​ 5, using the perpetuity with growth formula.b. You have identified several firms in the same industry as your operating division. The average​ P/E ratio for these firms is

19.

Estimate the continuation value assuming the​ P/E ratio for your division in year 5 will be the same as the average​ P/E ratio for the comparable firms today.c. The average​ market/book ratio for the comparable firms is

5.8.

Estimate the continuation value using the​ market/book ratio.

a. You forecast that future free cash flows after year 5 will grow at

2%

per​ year, forever. Estimate the continuation value in year​ 5, using the perpetuity with growth formula.The continuation value in year 5 is

​$nothing

million. ​ (Round to one decimal​ place.)

Answer 1

a. You forecast that future free cash flows after year 5 will grow at 2% per​ year, forever. Estimate the continuation value in year​ 5, using the perpetuity with growth formula.

Continuation value = FCF in year 5 * (1 + Growth rate) / (WACC- growth rate)

Continuation value = $102.50 M * (1 + 2%) / (10%- 2%)

Continuation value = $102.50 M * 1.02 / 8%

Continuation value = $1306.9 Million

b. You have identified several firms in the same industry as your operating division. The average​ P/E ratio for these firms is

19.Estimate the continuation value assuming the​ P/E ratio for your division in year 5 will be the same as the average​ P/E ratio for the comparable firms today.

Continuation value = Net income in year 5 * PE Ratio

Continuation value = $54.50 * 19

Continuation value = $1035.5 Million

c. The average​ market/book ratio for the comparable firms is 5.8. Estimate the continuation value using the​ market/book ratio.

Continuation value = Book Value in Year 5 * PE Ratio

Continuation value = $179 * 5.80

Continuation value = $1038.2 Million