Page 43 - FINAL CFA II SLIDES JUNE 2019 DAY 7

Three-Stage FCFE Model READING 30: FREE CASH FLOW VALUATION

EXAMPLE: Medina Classic Furniture, Inc. is expected to experience growth in three MODULE 30.5: FCF OTHER ASPECTS
distinct stages in the future. Its most recent FCFE is 0.90 Canadian dollars (C$) per
share. The following information has been compiled:

High-growth period: Transitional period: Stable-growth period:
• Duration = 3 years. • Duration = 3 years. • FCFE growth rate = 3%.
• FCFE growth rate = 30%. • FCFE growth will decline by 9% p/a down to the indicated stable growth rate. • Shareholders’ required return = 10%.
• Shareholders’ required return = 20%. • Shareholders’ required return = 15%.
Calculate the value of the firm’s equity using the three-stage FCFE model.

The transitional present values are computed using a combination of the 20% initial discount
rate and the transitional 15% rate. For example, the present value of FCFE is computed as:
5
We can calculate the terminal value of the stock as of Year 6 using the
FCFE projected for Year 7. Notice that we use the stage 3 required return
of 10%.

The changing discount rates were important here for a couple of reasons.
• First, the terminal value in Year 6 had to be discounted for three years at 20% and for
three years at 15%.
• Second, due to the changing discount rates, our financial calculator was not as helpful as
it was in other multiple cash flow calculations. It simply cannot handle the changing
discount rates in one easy set of calculations.