Free cash flow valuation You are evaluating the potential purchase of a small business with no debt or preferred stock that is currently generating $41 comma 300 of free cash flow (FCF 0 = $41,300 ). On the basis of a review of similar-risk investment opportunites, you must earn a (n) 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. a. What is the firm's value if cash flows are expected to grow at an annual rate of 0% from now to infinity? b. What is the firm's value if cash flows are expected to grow at a constant annual rate of 8 % from now to infinity? c. 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?

Question

Business

Giovanni Hansen

31 December, 11:18

Free cash flow valuation You are evaluating the potential purchase of a small business with no debt or preferred stock that is currently generating $41 comma 300 of free cash flow (FCF 0 = $41,300 ). On the basis of a review of similar-risk investment opportunites, you must earn a (n) 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. a. What is the firm's value if cash flows are expected to grow at an annual rate of 0% from now to infinity? b. What is the firm's value if cash flows are expected to grow at a constant annual rate of 8 % from now to infinity? c. 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?

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Answers (1)

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Keagan Brady · Answer 1

a. $229,444.44

b. $446,040

c. $438,326.23

Explanation:

a. Value of the firm will be calculated as the present value of the perpetuity. The perpetuity is FCF0 = 41,300. = > Value of firm = 41,300 / 0.18 = $229,444.44;

b. Apply the constant growth model for calculation value of the firm : FCF1 / (Required return - Growth rate) = (FCF0 x 1.08) x (18% - 8%) = (41,300 x 1.08) / 10% = $446,040;

c. Value of the firm = FCF1 / 1.18 + FCF2 / 1.18^2 + [FCF3 / (18% - 7%) ]/1.18^2

in which: FCF1 = FCF0 x 1.12 = $46,256; FCF2 = FCF1 x 1.12 = $51,807; FCF3 = FCF2 x 1.07 = $55,433

Value of the firm = $438,326.23