Your firm would like to evaluate a proposed new operating division. You have forecasted cash flows for this division for the next five years, and have estimated that the cost of capital is 12%. You would like to estimate a continuation value. You have made the following forecasts for the last year of your five year forecasting horizon (in millions of dollars):
Year 5 

Revenues 
1,200.0 
Operating income 
100.0 
Net income 
50.0 
Free cash flows 
110.0 
Book value of equity 
400.0 
a. You forecast that future free cash flows after year 5 will grow 2% per year, forever. Estimate the continuation value in year 5, using the perpetuity with growth formula.
b. You have identified several firms in the same industry as your operating division. The average P/E ratio for these firms is 30. Estimate the continuation value assuming the P/E ratio for your division in year 5 will be the same as the average P/E ratio for the comparable firms today.
c. The average market/book ratio for the comparable firms is 4.0. Estimate the continuation value using the market/book ratio.
Note:
Assume that all firms (including yours) have no debt.
*Make sure to round to one decimal place*
a. continuation value in year 5 = free cash flow year 5*(1+free cash flow growth rate)/(cost of capital  free cash flow growth rate)
continuation value in year 5 = 110*(1+0.02)/(0.12  0.02) = (110*1.02)/0.10 = 112.2/0.10 = 1,122.0
b. P/E ratio = Price/earnings or net income
average P/E ratio for the industry is 30 and for your division in year 5 will be the same as the average P/E ratio for the comparable firms today.
30 = Price/50
Price = 30*50 = 1,500.0
continuation value in year 5 using P/E ratio is 1,500.0.
c. market/book ratio = market value/book value
The average market/book ratio for the comparable firms is 4.0.
4 = market value/400
market value = 4*400 = 1,600.0
the continuation value using the market/book ratio is 1,600.0.
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