Question

# Your firm would like to evaluate a proposed new operating division. You have forecasted cash flows...

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.