Question

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: Market value of company FCF (1+WACC) + FCF (1+WACC) +...+ FCF (1+WACC) 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: Horizon value = V Company at t=n=FCFN+1/(WACC-8FCF) 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 $410 million and its 2018 depreciation expense will be $65 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 $30 million. The firm's free cash flow is expected to grow at a constant rate of 4.5% annually. Assume that its free cash flow occurs at the end of each year. The firm's weighted average cost of capital is 8.3%; the market value of the company's debt is $2.3 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. 1 Year 2 3 4 5 FCF -$22.73 $38.2 $43.2 $52.1 $55.8 The weighted average cost of capital is 9%, and the FCFs are expected to continue growing at a 3% rate after Year 5. The firm has $25 million of market value debt, but it has no preferred stock or any other outstanding claims. There are 21 million shares outstanding. What is the value of the stock price today (Year O)? Do not round intermediate calculations. Round your answer to the nearest cent. $ per share

Answer 1

1. Free cashflow2018=(EBIT*(1-tax rate))+depreciation-capital expenditure-net working capital

=410+65-110-30

=335 million

Value of the Firm=Free cashflow 2018/(cost of capital-growth rate)=335/(8.3%-4.5%)=$8815.79 million

Value of the equity=value of the firm-value of debt=$8815.79-$2,300=$6515.79 million

Value of share=Value of the equity/Shares outstanding=6515.79/180=$36.20

2. Horizon value at Year5=FCF6/(cost of capital-growth rate)

FCF6=FCF5*(1+growth rate)=$55.8*(1+3%)=$57.474 million

Horizon value=$57.474/(9%-3%)=$957.9 million

Value of the Firm=(FCF1/(1+9%))+(FCF2/(1+9%)^2)+(FCF3/(1+9%)^3)+(FCF4/(1+9%)^4)+((FCF5+Horizon value at year5/(1+9%)^5)

=(-22.73/1.09)+(38.2/1.09^2)+(43.2/1.09^3)+(52.1/1.09^4)+(1013.7/1.09^5)

=-20.85+32.15+33.36+36.91+658.84

=$740.40 million

Value of the equity=value of the firm-value of debt=$740.4-$25=$715.40 million

Value of share=Value of the equity/Shares outstanding=715.40/21=$34.07