Page 41 - FINAL CFA II SLIDES JUNE 2019 DAY 7

Two-Stage FCFF Model READING 30: FREE CASH FLOW VALUATION

EXAMPLE: PPC earned a net profit margin of 20% on revenues of
$20 million this year. Fixed capital investment was $2 million, and MODULE 30.5: FCF OTHER ASPECTS
depreciation was $3 million.
Working capital investment equals 7.5% of sales every year. Net income, fixed capital investment, depreciation, interest expense, and sales are expected to
grow at 10% per year for the next five years. After five years, the growth in sales, net income, fixed capital investment, depreciation, and interest expense
will decline to a stable 5% per year. The tax rate is 40%, and Prentice has 1 million shares of common stock outstanding and long-term debt paying 12.5%
interest trading at its par value of $32 million. Calculate the value of the firm and its equity using the FCFF model if the WACC is 17% during the
high-growth stage and 15% during the stable stage.

Let’s demonstrate the calculation of the FCFF in Year 0:

net income = $20.00 × 0.20 = $4.00
interest = $32.00 × 0.125 = $4.00
interest(1 − T) = $4.00 × (1 − 0.40) = $2.40

WCInv = $20.00 × 0.075 = $1.50

FCFF = $4.00 + $2.40 + $3.00 − $2.00 − $1.50 = $5.90
In Year 1, sales grow by 10% to $22.00 per share. Following five years of 10% growth,
the growth of each component falls to 5%.

The terminal value (as of Year 5, discounted at the stable WACC of 15%) is:

Notice that the WACC in the high-growth stage (17%) is different than the stable stage (15%). We
calculated terminal value in Year 5 using 15%, but we’ll calculate the present value today of the high-
growth cash flows and the terminal value at 17%. The total of the firm today is:

Fin Calc: CF = 0; C01 = 6.49; C02 = 7.13; C03 = 7.84; C04 = 8.63; C05 = 109.20 I = 17; CPT → NPV = 70.06
0
Thus, given that the value of the firm’s debt is $32 per share, the value of equity per share is $70.06 – $32.00 = $38.06.