Question

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.

(i) 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. Answer.

(ii) 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

	A.	Using the Finance Manager’s estimates of future free cash flows and the cost of equity capital
		Year	1	2	3	4
		Free Cash flows	50,00,000	60,00,000	70,00,000	80,00,000
		Terminal Value Y-3	-	-	5,71,42,857
		Total Cash flows	50,00,000	60,00,000	6,41,42,857
		PVF @ 14%	0.8772	0.7695	0.6750
		PV of Cash flows	43,85,964.91	46,16,805.17	4,32,94,601.54
		The present value of the company’s equity	5,22,97,371.62
	B.	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
		Year	1	2	3	4
		Free Cash flows	50,00,000	60,00,000	70,00,000	80,00,000
		Terminal Value Y-3	-	-	7,27,27,273
		Total Cash flows	50,00,000	60,00,000	7,97,27,273
		PVF @ 11%	0.9009	0.8116	0.7312
		PV of Cash flows	45,04,504.50	48,69,734.60	5,82,95,894.67
		The present value of the company’s equity	6,76,70,133.78
		Amount by which the Finance Manager’s calculation of the present value of the company’s equity is over- or under-valued
		The equity by Finance manager is undervalued by	1,53,72,762.15