Question

Which of the following statements about the FCF valuation model are true? Check all that apply.

A. The FCF valuation model reflects the firm's riskiness—as it affects the company's intrinsic value—via the WACC variable.

B. A company's FCFs are a function of how effectively managers control the firm's costs, manage its operating and nonoperating assets, and generate sales revenues.

C. The model is useful because it demonstrates the relationship between quality of the decisions that managers make and the value of their company.

D. The model can be applied to companies that either pay or do not pay a dividend—but it cannot be applied to privately-held companies

Next year, Red Rabbit is expected to earn an EBIT of $14,000,000, and to pay a federal-plus-state tax rate of 35%. It also expects to make $3,500,000 in new capital expenditures to support this level of business activity, as well as $20,000 in additional net operating working capital (NOWC).

Given these expectations, it is reasonable to conclude that next year Red Rabbit will generate an annual free cash flow (FCF) of      (rounded to the nearest whole dollar).

Next, based on your estimate of Red Rabbit’s next year’s FCF and making the stated assumptions, complete the following table:

•	Red Rabbit can sustain this annual FCF forever,
•	the company has a weighted average cost of capital of 17.10%,
•	the company does not currently own any marketable securities,
•	there are 30,000 shares of Red Rabbit outstanding
•	the company’s value of debt is 45% of its total entity value, and
•	the company’s value of preferred shares is 25% of its total entity value.

Attributes of Red Rabbit	Value
Total Entity Value
Value of Common Equity
Intrinsic value (per share)

Answer 1

1). The correct statements are:

A - the FCF valuation model reflects the firms riskiness ,as it affects the firms' intrinsic value via the WACC variable.

B - A company's FCFs are a function of how effectively managers control the firm's costs, manage its operating and nonoperating assets, and generate sales revenues.

C - The model is useful because it demonstrates the relationship between the quality of the decisions that managers make and the value of their company.

Statement D is wrong as FCF valuation model can be applied to privately held companies.

2). Next year's FCF = EBIT*(1-Tax rate) - New capex - NOWC

= 14,000,000*(1-35%) - 3,500,000 - 20,000 = 5,580,000

If this is the annual FCF in perpetuity then

Total entity value (TEV) = annual FCF/cost of capitl = 5,580,000/17.10% = 32,631,578.65

Equity value = TEV - debt value - preferred share value

= TEV*(1-(45%+25%)) = 32,631,578.65*(1-70%) = 9,789,473.68

Intrinsice value per share = Equity value/number of shares

= 9,789,473.68/30,000 = $326.32 per share