Question

Consider the following data:
FCF1 = $30 million; FCF2 = $45 million; FCF3 = $55 million. Assume that free cash flow grows at a rate of 5% for year 4 and beyond. If the weighted average cost of capital is 10%, calculate the value of the firm.

	A.	$973.55 million
	B.	$801.12 million
	C.	$867.77 million
	D.	$736.02 million
	E.	None of the above

2.

VFIC Industries has come up with a new mountain bike prototype and is ready to go ahead with pilot production and test marketing. The pilot production and test marketing phase will cost $100,000 and last for one year. The management team believes that there is a 30% chance that the test marketing will be successful and that there will be sufficient demand for the new mountain bike. If the test-marketing phase is successful, then VFIC will invest $2 million to build a plant immediately that will generate expected annual after-tax cash flows of $300,000 in perpetuity starting in year two. If the test marketing is not successful, VFIC can still go ahead and build the new plant, but the expected annual after-tax cash flows would be only $150,000 in perpetuity starting in year two. VFIC's cost of capital is 10%.

What is the NPV of the VFIC Mountain Bike Project?

	A.	$90,909
	B.	$172,727
	C.	$455,000
	D.	-$45,455
	E.	None of the above

Answer 1

1. Value of Firm = $973.55 Million Option A

1. Value of Firm ($ in Million)
Year	FCF	FCF - Terminal	Total FCF	PVF @ 10%	Discounted Value
1	$ 30.00		$      30.00	0.909090909	$                27.27
2	$ 45.00		$      45.00	0.826446281	$                37.19
3	$ 55.00	$       1,155.00	$ 1,210.00	0.751314801	$              909.09
Value of Firm					$              973.55

Terminal value = FCF 3 * (1 + Growth Rate) / (Required rate - growth rate)

Terminal value = $55 M * 1.05 / 5% = $1155 M

2. NPV = (probability of success * [(After tax cash flow/Required rate) - Investment] + probability of not success * [(After tax cash flow/Required rate) - Investment]) / (1 + Required rate)

NPV = (0.30 * [(300000/10%) - 2000000] + 0.70 * [(150000/10%) - 200000]) / (1 + 10%)

NPV = (0.30 * 1000000 + 0.70 * -500000 / (1 + 10%)

NPV = (-50000 / (1 + 10%)

NPV = -$45455 Option D

* Marketing cost is a sunk costs thus ignored