Question

Heavy Metal Corporation is expected to generate the following free cash flows over the next three years. Thereafter, the free cash flows are expected to grow at the industry average of 2% per year (so that Year 4 FCF is 2% larger than Year3 FCF, and so on). Using the discounted free cash flow model and a WACC of 9%, estimate the enterprise value of Heavy Metal. Year 1 2 3 FCF ($ million) 10 20 30 Select one: a. $335.5 million b. $437.1 million c. $386.7 million d. $467.1 million

Answer 1

Answer:

c. $386.7 million

Explanation:

The enterprise value of the firm is the present value of its future free cash flows discounted at the weighted average cost of capital as well as the present value of  free cash flow terminal value beyond year 3  as shown thus:

Year 1 FCF=$10 million

Year 2 FCF=$20 million

Year 3 FCF=$30 million

terminal value=Year 3 FCF*(1+terminal growth rate)/(WACC-terminal growth rate)

terminal growth rate=2%

WACC=9%

terminal value=$30*(1+2%)/(9%-2%)

terminal value=$437.14 million( $437.1 million  is wrong as it is the terminal value, not the enterprise value)

present value of FCF=FCF/(1+WACC)^n

n is the year in which the free cash flow is expected, it is 1 for year 1 FCF, 2 for year 2 FCF , 3 for year 3 FCF as well as the terminal (the terminal value is also stated  in year 3 terms)

enterprise value=$10/(1+9%)^1+$20/(1+9%)^2+$30/(1+9%)^3+$437.14 /(1+9%)^3

enterprise value= $386.7 milion