Question

Acquirer Company’s management believes that there is a 70 percent chance that Target Company’s free cash flow to the firm will grow at 25 percent per year during the next five years from this year’s level of $4 million. Sustainable growth beyond the fifth year is estimated at 5 percent per year. However, they also believe that there is a 30 percent chance that cash flow will grow at half that annual rate during the next five years and then at a 3.5 percent rate thereafter. The discount rate is estimated to be 14 percent during the high growth period and 11 percent during the sustainable growth period for each scenario. What is the expected value of Target Company?

Answer 1

Expected value of firm if free cash flow of firm grows by 25%

Year	FCF	PVIF @ 14%	Present value
1	5000000	0.8772	4385965
2	6250000	0.7695	4809172
3	7812500	0.6750	5273215
4	9765625	0.5921	5782034
5	12207031.25	0.5194	6339950
P5 = CF6/Ke-g =12207031.25(1.05)/11%-5% =12817382.81/6%	213623046.8	0.5194	110949117
Expected value			137539452

Expected value of firm if free cash flow of firm grows by 12.5%

Year	FCF	PVIF @ 14%	Present value
1	4500000	0.8772	3947368
2	5062500	0.7695	3895429
3	5695312.5	0.6750	3844174
4	6407226.563	0.5921	3793592
5	7208129.883	0.5194	3743677
P5 = CF6/Ke-g =7208129.88(1.035)/11%-3.5% =7460414.43/7.5%	99472192.4	0.5194	51662740
Expected value			70886980

Thus Expected value = 70%*137539452 + 30%*70886980

=96,277,616.4+21,266,094.14

=117,543,710.5$