How to calculate long term constant growth in fcf

1/6/15
Chapter 8 Mini Case
Situation
Your employer, a mid-sized human resources management company, is considering expansion into related fields, including the acquisition of Temp Force Company, an employment agency that supplies word processor operators and computer programmers to businesses with temporary heavy workloads. Your employer is also considering the purchase of a Biggerstaff & McDonald (B&M), a privately held company owned by two friends, each with 5 million shares of stock. B&M currently has free cash flow of $24 million, which is expected to grow at a constant rate of 5%. B&M’s financial statements report marketable securities of $100 million, debt of $200 million, and preferred stock of $50 million. B&M’s weighted average cost of capital (WACC) is 11%. Answer the following questions.
a. Describe briefly the legal rights and privileges of common stockholders.
Features of Common Stock
1. Common Stock represents ownership. 2. Ownership implies control. 3. Stockholders elect directors. 4. Directors hire management who attempt to maximize stock price.
Classified Stock
Classified Stock carries special provisions. For example, shares could be classified as founders' shares which come with voting rights but dividend restrictions.
b. What is free cash flow (FCF)? What is the weighted average cost of capital? What is the free cash flow valuation model?
c. Use a pie chart to illustrate the sources that comprise a hypothetical company’s total value. Using another pie chart, show the claims on a company’s value. How is equity a residual claim?
Data for charts
Column1
10
Mkt. Sec. 1
Claims on Value
Pref. Stk. 1
Debt 3
7
d. Suppose the free cash flow at Time 1 is expected to grow at a constant rate of gL forever. If gL < WACC, what is a formula for the present value of expected free cash flows when discounted at the WACC? If the most recent free cash flow is expected to grow at a constant rate of gL forever (and gL < WACC), what is a formula for the present value of expected free cash flows when discounted at the WACC?
If constant growth begins at Time 1:
If constant growth begins at Time 0:
e. Use B&M’s data and the free cash flow valuation model to answer the following questions.
INPUT DATA SECTION: Data used for valuation (in millions)
Free cash flow $24.0
WACC 11%
Growth 5%
Short-term investments $100.0
Debt $200.0
Preferred stock $50.0
Number of shares of stock 10.0
(1) What is its estimated value of operations?
Vop = FCF1 = FCF0 (1+gL)
(WACC-gL) (WACC-gL)
Vop = $25.2
0.06
Vop = $420.00
(2) What is its estimated total corporate value?
Value of Operation $420.0
Plus Value of Non-operating Assets $100.0
Total Corporate Value $520.0
(3) What is its estimated intrinsic value of equity?
Debt holders have the first claim on corporate value. Preferred stockholders have the next claim and the remaining is left to common stockholders.
Total Corporate Value $520.0
Minus Value of Debt $200.0
Minus Value of Preferred Stock $50.0
Intrinsic Value of Equity $270.0
(4) What is its estimated intrinsic stock price per share?
Intrinsic Value of Equity $270.0
Divided by number of shares 10.0
Intrinsic price per share $27.00
Estimating the Value of R&R’s Stock Price (Millions, Except for Per Share Data)
INPUTS:
Value of operations = $420.00
Value of nonoperating assets = $100.00
All debt = $200.00
Preferred stock = $50.00
Number of shares of common stock = 10.00
ESTIMATING PRICE PER SHARE
Value of operations $420.00
+ Value of nonoperating assets 100.00
Total estimated value of firm $520.00
− Debt 200.00
− Preferred stock 50.00
Estimated value of equity $270.00
÷ Number of shares 10.00
Estimated stock price per share = $27.00
f. You have just learned that B&M has undertaken a major expansion that will change its expected free cash flows to −$10 million in 1 year, $20 million in 2 years, and $35 million in 3 years. After 3 years, free cash flow will grow at a rate of 5%. No new debt or preferred stock were added, the investment was financed by equity from the owners. Assume the WACC is unchanged at 11% and it that there are still has 10 million shares of stock outstanding.
(1.) What is its horizon value (i.e., its value of operations at year three)? What is its current value of operations (i.e., at time zero)?
Explicit forecast:
Year 0 1 2 3
FCF FCF1 FCF2 FCF3
Constant growth from Year 3 and afterwards:
Year 0 1 2 3 4 5 … t
FCF FCF1 FCF2 FCF3 FCF3(1+gL) FCF4(1+gL) FCFt(1+gL)
Explicit forecast ends at Year 3, so make the horizon date Year 3, too. (Note: it is possible to make the horizon date Year 2 because FCF3 is known and grows at a constant rate, but it is easy to make mistakes if horizon year is not set equal to end of explicit forecast.)
HV3 = Vop,3 = PV of FCF4 and beyond discounted back to Year 3
Year 0 1 2 3 4 5 … t
FCF FCF3(1+gL) FCF4(1+gL) FCFt(1+gL)
HV3 ←↵ ←↵ ←↵
Because free cash flows are constant from Year 4 and beyond, we can apply the constant growth model at Year 3:
The general horizon value formula is:
R&R's explicit forecast:
Year 0