Question

Zhdanov Inc. forecasts that its free cash flow in the coming year, i.e., at t = 1, will be -$10 million, but its FCF at t = 2 will be $10 million. After Year 2, FCF is expected to grow at a constant rate of 5% forever. If the weighted average cost of capital is 15%, what is the firm’s value of operations, in millions?

Answer 1

Step-1, Calculation of the Horizon Value (HV)

Free Cash Flow in Year 2 (FCF2) = $10 Million

Growth Rate after 2^nd Years (g) = 5% per year

Weighted Average Cost of Capital (WACC) = 15%

Therefore, the Horizon Value (HV) = FCF2(1 + g) / (WACC – g)

= $10 Million(1 + 0.05) / (0.15 – 0.05)

= $10.50 Million / 0.10

= $105.00 Million

Step-2, Calculation of the firm's value of operations

Firm's value of operations is the Present Value of the free cash flows plus the present value of the Horizon Value discounted at WACC

Year	Cash flow ($ in Million)	Present Value factor at 15%	Present Value of cash flows ($ in Million)
1	-10.00	0.86957	-8.70
2	10.00	0.75614	7.56
2	105.00	0.75614	79.40
TOTAL			78.26

“Therefore, the firm's value of operations will be $78.26 Million”

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.