Question 18.A.3: Using the FCFF Income Approach PROBLEM: You have decided to...
Using the FCFF Income Approach
PROBLEM: You have decided to use the FCFF income approach to estimate the intrinsic value of the company that manufactures components for recreational vehicles. You expect cash flows to grow very rapidly during the next five years and to level off after that. Based on this, you forecast the cash flows for each of the next five years to be:
| Year | |||||
| 1 | 2 | 3 | 4 | 5 | |
| FCFF($millions) | −$0.284 | $0.108 | $0.998 | $2.110 | $2.857 |
You expect cash flows to be constant after year 5. There are no NOA in this firm. If the appropriate WACC is 9 percent, what is the enterprise value of this business? What is the value of the equity if the value of the company’s debt equals $1.25 million?
APPROACH: First calculate the total present value of the individual FCFF that you have forecast by discounting them to year 0 using the WACC and summing them up. Next, calculate the terminal value, assuming no growth in the cash flows after year 5, and discount this value to year 0. The enterprise value equals the present value of the individual cash flows plus the present value of the terminal value. The value of the equity can then be calculated by subtracting the value of the debt.
The present value of the cash flows in the first five years is:
\begin{matrix} PV(FCFF)_5 &=& \frac{-\$0.284 \ million}{1+0.09}+\frac{\$0.108 \ million}{(1+0.09)^2} +\frac{\$0.998 \ million}{(1+0.09)^3} + \frac{\$2.110 \ million}{(1+0.09)^4}+\frac{\$2.857 \ million}{(1+0.09)^5} \\ \\ &=& \$3.95 \ million\end{matrix}The present value of the terminal value is:
PV(TV_5)=\frac{TV_5}{(1+WACC)^5}=\frac{\$2.857 \ million/(0.09-0)}{(1+0.09)^5}=\$20.63 \ millionTherefore, the total enterprise value is:
\begin{matrix} V_F &=& PV(FCF_T)+PV(TV_T)+NOA=\$3.95 \ million +\$20.63 \ million+ \$0 \ million \\ &=& \$24.58 \ million \end{matrix}and the value of the equity equals $24.58 million − $1.25 million = $23.33 million.