Question

Diversified Industries, Inc. forecasts that its free cash flow in the coming year, i.e., at t = 1, will be -$18 million (negative), but its FCF at t = 2 will be $33 million. After Year 2, FCF is expected to grow at a constant rate of 4% forever. If the weighted average cost of capital is 15%, what is the firm's value of operations, in millions? Enter your answer rounded to two decimal places. Do not enter $ or comma in the answer box. For example, if your answer is $12,300.456 then enter as 12300.46 in the answer box.

Answer 1

Sol:

Total value of the firm is PV of cash flows plus Horizon value

Year	Cash Flows (in millions)	PV factor @15%	Discounted cash flows (PV) (in millions)
1	-18	0.8696	-15.65
2	33	0.7561	24.95
3	312	0.7561	235.92
Total value of the firm	245.22

FCF in year 2 = 33 million

WACC = 15%

Growth rate (r) = 4%

Horizon value (HV) = FCF in year 2 x (1+r) / (WACC - r)

Horizon value (HV) = 33 million x (1+4%) / (15% - 4%)

Horizon value (HV) = 33 million x (1+0.04) / (0.15 - 0.04)

Horizon value (HV) = 33 million x 1.04 / (0.11)

Horizon value (HV) = 34.32 / 0.11

Horizon value (HV) = 312 million

Therefore total value of the firm is $245.22 million.

Workings