Answer the following questions regarding free cash flow model and its differences with the dividend discount...

Answer the following questions regarding free cash flow model and its differences with the dividend discount model.

Write out the equation for the value of operations.
Explain how to use the free cash flow valuation model to find the price per share of common equity.
What are value drivers? Does an increase in the operating profitability ratio always cause an increase in the value of operations? Does a decrease in the capital requirement ratio always cause an increase in the value of operations? Does an increase in the long-term growth rate of free cash flows always cause an increase in the value of operations? Explain your answers.
Theoretically, should the dividend discount model and free cash flow model yield the same stock price? Explain.
What are the advantages and disadvantages of the free cash flow valuation model relative to the dividend growth model? What situation is ideally suited to valuation with the dividend growth model?

Solutions

Expert Solution

Q-1)

The value of the firm from the free cash flow model is equal to the

Value of the firm = Expected free cash flow to the firm/(Required rate – growth rate)

The expected free cash flow is the free cash flow for the year 1 and required rate is the weighted average cost of capital for the firm, growth rate is the growth rate in the free cash flow of the firm.

Q-2)

The way we use the free cash flow valuation model to value the common stock is we first calculate the total value of the firm by using the above formula. Then we take the market value of debt and subtract it from the total value of the firm. Here we got the total value of the equity, to calculate the per share value of the stock we divide the total value of the equity by the total outstanding shares for the company.

Q-3)

The value drivers for a free cash flow to the firms are the free cash flow being generated and the rate at which they are growing. The increase in operating profitability might not always lead to increase in free cash flow as if the non-operating expenses (Other than interest) are high then the free cash flow would not increase, also if the WACC increases then the value of the operation will not increase. Decrease in capital requirement might increase the return on capital but it will not always increase the value of operation. Increase in the growth rate of the free cash flow of the company will lead to an increase in the value of the operation as growth is one of the key variables in the FCFF model.

Q-4)

Theoretically the dividend discount model and FCFF model should lead to the same price of the stock because in FCFF model we are separating the market value of debt to value the equity. In the dividend discount model, the equity share value is being derived directly buy theoretically both models should result in same valuation.

Q-5)

The major advantage if free cash flow model is it can be used to value a company even who is not paying dividend and even if the company is not generating net profits, we can use the free cash flow model to value the entire company as to what is the present worth of this company. The disadvantage of this model is there are many assumptions regarding growth rate, WACC and the expected free cash flow and terminal value of the free cash flow, if the assumptions are biased then the output from the model will also be biased and will not be reliable. The model is as good the data input with in the model. Dividend valuation model is suitable for companies which has been paying dividends over the last few years and it is expected to do so and its growth rate can be predicted easily.

jeff jeffy answered 1 year ago

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