Question

1. As a finance consultant, you have advised XYZ Ltd to use the free cash flow method to value its equity. The Finance Manager of the company has advised that she estimates the free cash flows to be $5 million in one year’s time, $6 million in 2 years’ time, $7 million in 3 years’ time and a constant $8 million every year thereafter. The Finance Manager wishes to use a cost of equity capital of 14% per annum, but after investigation of the company’s activities, you believe that 11% per annum is a more realistic cost of equity and in line with industry estimates.

                                                                                                                1.5 + 1.5 + 1 = 4 Marks

1. Using the Finance Manager’s estimates of future free cash flows and the cost of equity capital (14% per annum), calculate the present value of the company’s equity.
2. Still using the Finance Manager’s estimates of future free cash flows, but on the assumption that your own estimate of the cost of equity capital (11% per annum) is the actual figure, calculate the amount by which the Finance Manager’s calculation of the present value of the company’s equity is over- or under-valued.  

Answer 1

Given cashflows,

Year1=$5 million

Year2=$6 million

Year3=$7 million

Present value of the equity at 14% cost of equity (assumption by finance manager)

Year4=$8 million constant there after, hence growth rate=0

Terminal value at year3=Year4 cashflow/(cost of equity-growth rate)=$8/14%=$57.14 million

i) Present value of equity (14% cost)=(F1/(1+14%))+(F2/(1+14%)^2)+((F3+Terminal value at Year3)/(1+14%)^3)

=($5/1.14)+(6/1.14^2)+(64.14/1.14^3)

=$52.30 million (round off two decimals)

=$52,297,371.62   

ii) Present value of the equity at 11% cost of equity (assumption by you)

Year4=$8 million constant there after, hence growth rate=0

Terminal value at year3=Year4 cashflow/(cost of equity-growth rate)=$8/11%=$72.73 million

Present value of equity (11% cost)=(F1/(1+11%))+(F2/(1+11%)^2)+((F3+Terminal value at Year3)/(1+11%)^3)

=($5/1.11)+(6/1.11^2)+(79.73/1.11^3)

=$67.67 million   (round off two decimals)

=67,670,133.78

The Finance manager present value of the equity is under valued by ($67,,670-133.78-$52,297,371.62) $15,372762.15