Question

12. 3: Basic Stock Valuation: Free Cash Flow Valuation Model Basic Stock Valuation: Free Cash Flow Valuation Model The recognition that dividends are dependent on earnings, so a reliable dividend forecast is based on an underlying forecast of the firm's future sales, costs and capital requirements, has led to an alternative stock valuation approach, known as the free cash flow valuation model. The market value of a firm is equal to the present value of its expected future free cash flows: Free cash flows are generally forecasted for 5 to 10 years, after which it is assumed that the final forecasted free cash flow will grow at some long-run constant rate. Once the firm reaches its horizon date, when cash flows begin to grow at a constant rate, the equation to calculate the continuing value of the firm at that date is: Discount the free cash flows back at the firm's weighted average cost of capital to arrive at the value of the firm today. Once the value of the firm is calculated, the market value of debt and preferred are subtracted to arrive at the market value of equity. The market value of equity is divided by the number of common shares outstanding to estimate the firm's intrinsic per-share value. We present 2 examples of the free cash flow valuation model. In the first problem, we assume that the firm is a mature company so its free cash flows grow at a constant rate. In the second problem, we assume that the firm has a period of nonconstant growth. Quantitative Problem 1: Assume today is December 31, 2017. Barrington Industries expects that its 2018 after-tax operating income [EBIT(1 – T)] will be $450 million and its 2018 depreciation expense will be $60 million. Barrington's 2018 gross capital expenditures are expected to be $110 million and the change in its net operating working capital for 2017 will be $25 million. The firm's free cash flow is expected to grow at a constant rate of 5% annually. Assume that its free cash flow occurs at the end of each year. The firm's weighted average cost of capital is 8.2%; the market value of the company's debt is $2.45 billion; and the company has 180 million shares of common stock outstanding. The firm has no preferred stock on its balance sheet and has no plans to use it for future capital budgeting projects. Using the free cash flow valuation model, what should be the company's stock price today (December 31, 2017)? Do not round intermediate calculations. Round your answer to the nearest cent. $ per share Quantitative Problem 2: Hadley Inc. forecasts the year-end free cash flows (in millions) shown below. Year 1 2 3 4 5 FCF -$22.06 $38.5 $43.6 $51.5 $55 The weighted average cost of capital is 9%, and the FCFs are expected to continue growing at a 4% rate after Year 5. The firm has $24 million of market-value debt, but it has no preferred stock or any other outstanding claims. There are 18 million shares outstanding. What is the value of the stock price today (Year 0)? Do not round intermediate calculations. Round your answer to the nearest cent. $ per share According to the valuation models developed in this chapter, the value that an investor assigns to a share of stock is dependent on the length of time the investor plans to hold the stock. The statement above is . Conclusions Analysts use both the discounted dividend model and the free cash flow valuation model when valuing mature, dividend-paying firms; and they generally use the corporate model when valuing divisions and firms that do not pay dividends. In principle, we should find the same intrinsic value using either model, but differences are often observed. Even if a company is paying steady dividends, much can be learned from the corporate model; so analysts today use it for all types of valuations. The process of projecting future financial statements can reveal a great deal about a company's operations and financing needs. Also, such an analysis can provide insights into actions that might be taken to increase the company's value; and for this reason, it is integral to the planning and forecasting process.

Answer 1

Quantitative Problem 1:

To calculate company's stock price we use free cash flow valuation model

Free cash flow at the end of each year = EBIT *(1- Tax rate ) + Depreciation - Capex - Change in Working capital

		2018
	EBIT(1-T)	450
Add (+)	Depreciation	60
Less (-)	Capital expenditure	110
Less (-)	Change in working capital	25
	Free cash flow	375

Thus free cash flow = $375 million

Given growth rate of free cash flow (g) = 5%

Weighted Average cost of capital (WACC)= 8.2%

Thus Valuation of the firm ₂₀₁₇ = FCFF₂₀₁₈ / ( WACC - g) =$ 375 / (8.2%- 5%) =$ 11718.75 million = $11.71875 billion

Market value of debt =$ 2.45 billion

Thus market value of equity = Value of the firm - Market value of debt = $11.71875 billion -$ 2.45 billion =$ 9.26875 billion

Stock price per share = market value of equity / No. of shares =$ 9.26875 billion / 180 million =$ 51.49306

Quantitative Problem 2:

Present value of free cash flow = FCFF_n / (1+ WACC)ⁿ for nth year of free cash flow

Present value of free cash flow ( year 1) = FCFF₁ / ( 1+ WACC)¹ = $22.1 million / (1+ 9%)¹ = $ 20.2385 million

Present value of free cash flow ( year 2) = FCFF₂ / ( 1+ WACC)² = $38.5 million/ (1+ 9%)² = $ 32.4046 million

Present value of free cash flow ( year 3) = FCFF₃ / ( 1+ WACC)³ = $43.6 million/ (1+ 9%)³ = $ 33.6672 million

Present value of free cash flow ( year 4) = FCFF₄ / ( 1+ WACC)⁴ = $51.5 million/ (1+ 9%)⁴ = $ 36.4839 million

Present value of free cash flow ( year 5) = FCFF₅ / ( 1+ WACC)⁵ = $55 million/ (1+ 9%)⁵ = $ 35.7462 million

Terminal cash flow at year n = FCFF_n *(1 +g) / (WACC - g)

Terminal cash flow at year 5 = FCFF₅ *(1 +g) / (WACC - g) =$ 55 million *(1+4%) / (9%-4%) = $ 1144 million

Present value of terminal cash flow ( year 5) = Terminal cash flow at year 5 / ( 1+ WACC)⁵ = $1144 million / (1+ 9%)⁵

= $ 743.5215 million

Value of the firm = sum of all present values = $ 902.062 million

Market value of debt =$ 24 million

Thus market value of equity = Value of the firm - Market value of debt = $902.062 million -$ 24 million =$ 878.062 million

Stock price per share = market value of equity / No. of shares =$ 878.062 million / 18 million =$ 48.78122