Question

The Home Appliance Industry had free cash flow to equity (FCFE) of $87 million for the most recent year ending reported yesterday. The industry anticipates a growth rate of 8% for the next three years due to favorable economic conditions. However, the growth rate is expected to decline to 4% after three years and remain at that level indefinitely. The required rate of return is 12% for this industry a) Calculate the FCFE at the end of the 8% growth period three years from now b) Calculate the intrinsic value of the Home Appliance Industry today

Answer 1

a). FCFE1 = FCFE0 * (1 + g1) = $87 million * (1 + 0.08) = $93.96 million

FCFE2 = FCFE1 * (1 + g1) = $93.96 million * (1 + 0.08) = $101.48 million

FCFE3 = FCFE2 * (1 + g1) = $101.48 million * (1 + 0.08) = $109.59 million

b). FCFE4 = FCFE3 * (1 + gC) = $109.59 million * (1 + 0.04) = $113.98 million

V3 = FCFE4/(r - gC)

= $113.98 million / [0.12 - 0.04] = $113.98 million / 0.08 = $1,424.73 million

V0 = [FCFE1/(1+r)] + [FCFE2/(1+r)²] + [(FCFE3+V3)/(1+r)³]

= [93.96/(1+0.12)] + [101.48/(1+0.12)²] + [(109.59+1,424.73)/(1+0.12)³]

= 83.89 + 80.90 + 1,092.11 = $1,256.89 million