Question

The recognition that dividends are dependent on earnings, so a reliable dividend forecast is based on an underlying forecast of the firm's future sales, costs and capital requirements, has led to an alternative stock valuation approach, known as the corporate valuation model. The market value of a firm is equal to the present value of its expected future free cash flows plus the market value of its non-operating assets:

Free cash flows are generally forecasted for 5 to 10 years, after which it is assumed that the final forecasted free cash flow will grow at some long-run constant rate. Once the firm reaches its horizon date, when cash flows begin to grow at a constant rate, the equation to calculate the continuing value of the firm's operations at that date is:

Discount the free cash flows back at the firm's weighted average cost of capital to arrive at the value of the firm today. Once the value of the firm's operations are calculated and the value of non-operating assets are added, then the market value of debt and preferred are subtracted to arrive at the market value of equity. The market value of equity is divided by the number of common shares outstanding to estimate the firm's intrinsic per-share value.

*We present 2 examples of the corporate valuation model. In
the first problem, we assume that the firm is a mature company so
its free cash flows grow at a constant rate. In the second problem,
we assume that the firm has a period of nonconstant
growth.*

**Quantitative Problem 1:** Assume today is
December 31, 2019. Barrington Industries expects that its 2020
after-tax operating income [EBIT(1 – T)] will be $420 million and
its 2020 depreciation expense will be $60 million. Barrington's
2020 gross capital expenditures are expected to be $120 million and
the change in its net operating working capital for 2020 will be
$20 million. The firm's free cash flow is expected to grow at a
constant rate of 5% annually. Assume that its free cash flow occurs
at the end of each year. The firm's weighted average cost of
capital is 8.6%; the market value of the company's debt is $2.6
billion; and the company has 190 million shares of common stock
outstanding. The firm has no preferred stock on its balance sheet
and has no plans to use it for future capital budgeting projects.
Also, the firm has zero non-operating assets. Using the corporate
valuation model, what should be the company's stock price today
(December 31, 2019)? Do not round intermediate calculations. Round
your answer to the nearest cent.

$ per share

**Quantitative Problem 2:** Hadley Inc. forecasts
the year-end free cash flows (in millions) shown below.

Year | 1 | 2 | 3 | 4 | 5 |

FCF | -$22.68 | $39 | $43.8 | $51.9 | $55.7 |

The weighted average cost of capital is 10%, and the FCFs are
expected to continue growing at a 5% rate after Year 5. The firm
has $26 million of market-value debt, but it has no preferred stock
or any other outstanding claims. There are 21 million shares
outstanding. Also, the firm has zero non-operating assets. What is
the value of the stock price today (Year 0)? Round your answer to
the nearest cent. Do not round intermediate calculations.

$ per share

According to the valuation models developed in this chapter, the value that an investor assigns to a share of stock is dependent on the length of time the investor plans to hold the stock.

The statement above is -Select-truefalseCorrect 2 of Item 2.

**Conclusions**

Analysts use both the discounted dividend model and the corporate valuation model when valuing mature, dividend-paying firms; and they generally use the corporate model when valuing divisions and firms that do not pay dividends. In principle, we should find the same intrinsic value using either model, but differences are often observed.

Even if a company is paying steady dividends, much can be learned from the corporate model; so analysts today use it for all types of valuations. The process of projecting future financial statements can reveal a great deal about a company's operations and financing needs. Also, such an analysis can provide insights into actions that might be taken to increase the company's value; and for this reason, it is integral to the planning and forecasting process.

Answer #1

EBIT(1-T) = $420 million

Add: Depreciation 60 million

Less: Gross Capital Expenditure = $120 million

Increase in Net Operating Working capital = $20 million

Free cash flow = $340 million

Firm Value = Free cash flow next year/(WACC – growth rate)

= 340/(8.6%-5%)

= $9,444.44 million

Less: Value of debt = $2,600 million

Value of Equity = $6,844.44 million

Number of shares = 190 million

Intrinsic value per share = $36.02

2.Enterprise value = present value of all future free cash flows

= -22.68/(1.10)+39/(1.10)^2 + 43.8/(1.10)^3 + 51.9/(1.10)^4 + 55.7/(1.10)^5 + 55.7(1.05)/(1.10)^5(10%-5%)

= 840.85 million

Value per share = (840.85 – 26)/21

= $38.80 per share

3. 3: Stocks and Their Valuation: Corporate Valuation
Model
The recognition that dividends are dependent on earnings, so a
reliable dividend forecast is based on an underlying forecast of
the firm's future sales, costs and capital requirements, has led to
an alternative stock valuation approach, known as the corporate
valuation model. The market value of a firm is equal to the present
value of its expected future free cash flows plus the market value
of its non-operating assets:
Free cash flows...

We present 2 examples of the corporate valuation model. In
the first problem, we assume that the firm is a mature company so
its free cash flows grow at a constant rate. In the second problem,
we assume that the firm has a period of nonconstant
growth.
a.
Assume today is December 31, 2019. Barrington Industries expects
that its 2020 after-tax operating income [EBIT(1 – T)] will be $410
million and its 2020 depreciation expense will be $60 million.
Barrington's...

Assume today is December 31, 2019. Barrington Industries expects
that its 2020 after-tax operating income [EBIT(1 – T)] will be $430
million and its 2020 depreciation expense will be $65 million.
Barrington's 2020 gross capital expenditures are expected to be
$110 million and the change in its net operating working capital
for 2020 will be $30 million. The firm's free cash flow is expected
to grow at a constant rate of 5% annually. Assume that its free
cash flow occurs...

Assume that today is December 31, 2019, and that the following
information applies to Abner Airlines:
After-tax operating income [EBIT(1 - T)] for 2020 is expected to
be $450 million.
The depreciation expense for 2020 is expected to be $190
million.
The capital expenditures for 2020 are expected to be $225
million.
No change is expected in net operating working capital.
The free cash flow is expected to grow at a constant rate of 6% per
year.
The required return...

Assume that today is December 31, 2019, and that the following
information applies to Abner Airlines: After-tax operating income
[EBIT(1 - T)] for 2020 is expected to be $700 million. The
depreciation expense for 2020 is expected to be $70 million. The
capital expenditures for 2020 are expected to be $300 million. No
change is expected in net operating working capital. The free cash
flow is expected to grow at a constant rate of 4% per year. The
required return...

Assume that today is December 31, 2019, and that the following
information applies to Abner Airlines: After-tax operating income
[EBIT(1 - T)] for 2020 is expected to be $700 million. The
depreciation expense for 2020 is expected to be $200 million. The
capital expenditures for 2020 are expected to be $475 million. No
change is expected in net operating working capital. The free cash
flow is expected to grow at a constant rate of 4% per year. The
required return...

Assume that today is December 31, 2019, and that the following
information applies to Abner Airlines:
After-tax operating income [EBIT(1 - T)] for 2020 is expected to
be $600 million.
The depreciation expense for 2020 is expected to be $100
million.
The capital expenditures for 2020 are expected to be $200
million.
No change is expected in net operating working capital.
The free cash flow is expected to grow at a constant rate of 6% per
year.
The required return...

Assume that today is December 31, 2019, and that the following
information applies to Abner Airlines:
After-tax operating income [EBIT(1 - T)] for 2020 is expected to
be $550 million.
The depreciation expense for 2020 is expected to be $150
million.
The capital expenditures for 2020 are expected to be $450
million.
No change is expected in net operating working capital.
The free cash flow is expected to grow at a constant rate of 7% per
year.
The required return...

Assume that today is December 31, 2019, and that the following
information applies to Abner Airlines:
After-tax operating income [EBIT(1 - T)] for 2020 is expected to
be $650 million.
The depreciation expense for 2020 is expected to be $100
million.
The capital expenditures for 2020 are expected to be $350
million.
No change is expected in net operating working capital.
The free cash flow is expected to grow at a constant rate of 4% per
year.
The required return...

Assume that today is December 31, 2019, and that the following
information applies to Abner Airlines:
After-tax operating income [EBIT(1 - T)] for 2020 is expected to
be $650 million.
The depreciation expense for 2020 is expected to be $140
million.
The capital expenditures for 2020 are expected to be $425
million.
No change is expected in net operating working capital.
The free cash flow is expected to grow at a constant rate of 5% per
year.
The required return...

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