Question

Bay Properties is considering starting a commercial real estate division. It has prepared the following​ four-year forecast of free cash flows for this​ division:

	year 1	year 2	year 3	year 4
Free Cash Flow	-132,000	15,000	85,000	239,000

Assume cash flows after year 4 will grow at 5 % per​ year, forever. If the cost of capital for this division is 8 %​,

a. what is the continuation value in year 4 for cash flows after year​ 4?

b. What is the value today of this​ division?

Please answer both questions and show all work!

Answer 1

(a)-The continuation value in year 4 for cash flows after year 4

Free Cash Flow in Year 4 (FCF4) = $239,000

Growth Rate (g) = 5.00% per year

Required Rate of Return (Ke) = 8.00%

Therefore, the Continuation Value in Year 4 = FCF4(1 + g) / (Ke – g)

= $239,000(1 + 0.05) / (0.08 – 0.05)

= $250,950 / 0.03

= $8,365,000

“The continuation value in year 4 for cash flows after year 4 = $8,365,000”

(b)-Value of this division today

Value of this division today is the Present value of the free cash flows plus the present value of the continuation value in year 4

Year	Cash flow ($)	Present Value factor at 8.00%	Present Value of cash flows ($ in Millions)
1	-1,32,000	0.92592593	-1,22,222.22
2	15,000	0.85733882	12,860.08
3	85,000	0.79383224	67,475.74
4	2,39,000	0.73502985	1,75,672.13
4	83,65,000	0.73502985	61,48,524.72
TOTAL			62,82,310.45

“Therefore, the Value of this division today would be $6,282,310.45”

NOTE

The Formula for calculating the Present Value Factor is [1/(1 + r)ⁿ], Where “r” is the Discount/Interest Rate and “n” is the number of years.