3. Fundamentals of the free cash flow corporate valuation model Aa Aa Several me

Question

3. Fundamentals of the free cash flow corporate valuation model Aa Aa Several methods can be used to compute the intrinsic value of a share of a company's common stock. One method uses the free cash flow (FCF) valuation model, while the another method uses the dividend discount model The FCF valuation model computes a firm's rket value-also called itseqityvalue-as the sum of the value of its operating activities (Vop) and the value of firm's nonoperating where: Vop is computed by cost of capital. the firm's expected future free cash flows by its weighted average A firm's nonoperating assets include its highly marketable invests its temporarily available excess cash, and its investments in other businesses. securities in which a firm Which of the following statements about the FCF valuation model are true? The model has limited applicability because it fails to adjust for a firm's riskiness-particularly that created by managers' decisions to use debt in the firm's capital structure, or decisions regarding the payment of cash dividends The model is useful because it examines the relationship between a company's risk, operating profitability, and value of the firm's operations. company's FCFs are a function of how efficiently and effectively the firm's managers use the company's operating assets and, in turn, the profitability of the company's primary business activities. The FCF valuation model reflects the firm's riskiness-as it affects the company's intrinsic value-via the WACC

Explanation / Answer

a)

non operating assets

Discounting expected future cash flow by its WACC

marketable liquid securities

b) Answer: D

The FCF valuation model reflects the firms riskiness, as it effects the company intrinsic value via WACC variable

c) FCFF = EBIT(1-T)+Depreciation/amortization-Capex-change in net working capital

= 5000000(1-35%) + 0 - 1250000 - 25000

= 1975000

d) as per the assumption FCF is same every year,

1) total entity value = FCF/(1+WACC)1 + FCF/(1+WACC)2 + ............

= FCF/WACC -1 = 1975000/7.46% = 26474530.8

2) value of common equity = 26474530.8

value of equity is same as value of entity as there no marketable securities

3) Intrinsic value = value of equity/number of shares = 26474530.8/37500 = 705.98

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