125.

230 Business Finance Test Review Tutorial

1. Free Cash Flow Valuation

Dance Monkey Ltd forecasts that its free cash flow in the coming year, i.e. at t =
1, will be $600,000, but its FCF at t = 2 will be $800,000. After Year 2, FCF is
expected to grow at a constant rate of 3% per year, forever.

a) If the weighted average cost of capital is 10%, what is the firm’s value of
assets?

b) The firm has $5,000,000 in long-term debt, $1,000,000 in preference shares,

and there are $1.2 million ordinary shares outstanding. What is the firm’s
estimated value per ordinary share?

Answer

a)
FCF1: $600,000
FCF2: $800,000
g: 3%
WACC: 10%

1. Estimate FCF up to and including year of constant growth:

Year 1: $600,000
Year 2: $800,000
Year 3: $800,000 * (1+g) = $800,000 * (1.03) = $824,000

2. Find the PV of the Initial FCF:

PV0 = $600,000/(1.10)1 + $800,000/(1.10)2 = $1,206,612

3. Find the PV of the FCF from Year 3 onwards

First, find the value at time 2:

PV2 = FCF2(1 + g)/(WACC – g) = $800,000*(1.03)/(0.10 – 0.03) = $11,771,429

Then find the PV at time zero

PV0 = $11,771,429/1.102 = $9,728,453
4. Sum the PVs of the free cash flows and the horizon value:
Value of assets = $1,206,612 + $9,728,453 = $10,935,065

b)
Value of equity = Value of total assets – value of debt – value of preference
shares
= $10,935,065 – $5,000,000 - $1,000,000 = $4,935,0,65

Price per share = Value of equity/Number of shares outstanding

= $4,935,0,65/1,200,000 shares = $4.11
2. Variable Growth Model

Blinding Lights Ltd has just paid a $1.00 dividend per share. The firm is
experiencing rapid growth which is expected to see its dividends grow at 10%
for two years and then the rate of growth will drop to 3% for year three
onwards. What is the value of Blinding's shares if the required rate of return is
10%?

Answer:

N
D0 x (1 + g1 )t 1 DN + 1
P0 = t
+ N
x
(1 + 𝑟s ) (1 + rs ) (rs – g2 )
t=1

1. Work out the expected dividends over the next three years;
g1 = 0.10, g2 = 0.03

D0 = 1.00
D1 = 1.00(1.1) = 1.10
D2 = 1.1(1.1) = 1.21 up to constant growth
DN+1 = D3 = 1.21(1.03) = 1.2463 after constant growth
g2 = 0.03

2. Find out the PV at time zero of the dividends in year 1 and 2 using the required
rate of return as the discount rate.

P0 = 1.1/1.101 + 1.21/1.102 = $2.00

3. Then determine the value of all dividends from years 3 onwards using the
constant growth formula.

D3
P2 =
r–g

1.2463
P2 = = 17.8043
0.10 - 0.03

4. Find the PV at time zero of step 3 above.

P0 = 17.8043/1.102 = 14.7143

5. Finally add PVs from steps 2 and 4 together.

P0 = $2.00 + $14.7143 = $16.71

3. Bond Valuation

Three years ago, Tootsie Ltd issued 10-year, 5% semi-annual coupon bonds at
their par value of $1,000. Today, the market interest rate on these bonds is 4.5%.
What is the current price of the bonds today?

Answer:

Coupon payment = 0.05/2 × $1,000 = $25,

r/2 =0.045/2 = 0.0225
n-3=10 – 3 = 7 × 2 = 14 periods remaining to maturity
M=1000.

C 1 M
B0 = 1- +
r (1+r)n (1 + r)n

25 1 1,000
B0 = 1- +
0.0225 (1.0225)14 (1.0225)14

= $297.40 + $732.34 = $1,029.74