Question

Free cash flow valuation You are evaluating the potential purchase of a small business with no debt or preferred stock that is currently generating $42,500 of free cash flow (FCF0=$42,500)(FCF0=$42,500). On the basis of a review of similar-risk investment opportunities, you must earn an 18% rate of return on the proposed purchase. Because you are relatively uncertain about future cash flows, you decide to estimate the firm’s value using several possible assumptions about the growth rate of cash flows.

1. What is the firm’s value if cash flows are expected to grow at an annual rate of 0% from now to infinity?
2. What is the firm’s value if cash flows are expected to grow at a constant annual rate of 7% from now to infinity?
3. What is the firm’s value if cash flows are expected to grow at an annual rate of 12% for the first 2 years, followed by a constant annual rate of 7% from year 3 to infinity?

Answer 1

a.

firm value = FCF/rate of return = 42500/0.18=236111.11

b.

firm or enterprise value= recent FCF* (1 + growth rate )/(WACC - growth rate)

Firm/enterprise value = 42500 * (1+0.07) / (0.18 - 0.07)

Firm/enterprise value = 413409.09

c.

	WACC=	18.00%
Year	Previous year FCF	FCF growth rate	FCF current year	Horizon value	Total Value	Discount factor	Discounted value
1	42500	12.00%	47600		47600	1.18	40338.9831
2	47600	12.00%	53312	518580.364	571892.364	1.3924	410724.1913
	Long term growth rate (given)=	7.00%			Value of Enterprise =	Sum of discounted value =	451063.17

Where
Current FCF =	Previous year FCF*(1+growth rate)^corresponding year
Total value = FCF	+ horizon value (only for last year)
Horizon value =	FCF current year 2 *(1+long term growth rate)/( WACC-long term growth rate)
Discount factor=	(1+ WACC)^corresponding period
Discounted value=	total value/discount factor