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Unformatted text preview: d of year 5 to infinity.9 This model is methodologically similar to
the variable-growth model presented earlier. Its application is best demonstrated
with an example.
EXAMPLE Dewhurst Inc. wishes to determine the value of its stock by using the free cash
flow valuation model. In order to apply the model, the firm’s CFO developed the
data given in Table 7.4. Application of the model can be performed in four steps.
Step 1 Calculate the present value of the free cash flow occurring from the end
of 2009 to infinity, measured at the beginning of 2009 (that is, at the end
of 2008). Because a constant rate of growth in FCF is forecast beyond
2008, we can use the constant-growth dividend valuation model (Equation 7.5) to calculate the value of the free cash flows from the end of
2009 to infinity.
Value of FCF2009 ∞ FCF2009
0.06 TABLE 7.4 (1 0.03)
$10,300,000 Dewhurst Inc.’s Data for Free Cash Flow
Valuation Model Free cash flow
Year (t ) (FCFt)a 2004 $400,000 2005 450,000 Other data
Growth rate of FCF, beyond 2008 to infinity, gFCF
Weighted average cost of capital, ka 3% 9% 2006 520,000 Market value of all debt, VD $3,100,000 2007 560,000 Market value of preferred stock, VP 2008 600,000 Number of shares of common stock outstanding aDeveloped $800,000
300,000 using Equations 3.2 and 3.3 (page 106). 9. The approach demonstrated here is consistent with that found in Alfred Rappaport, Creating Shareholder Value
(New York: The Free Press, 1998). A somewhat similar approach to value can be found in G. Bennett Stewart III,
The Quest for Value (New York: HarperCollins, 1999). 332 PART 2 Important Financial Concepts Note that to calculate the FCF in 2009, we had to increase the 2008 FCF
value of $600,000 by the 3% FCF growth rate, gFCF.
Step 2 Add the present value of the FCF from 2009 to infinity, which is measured
at the end of 2008, to the 2008 FCF value to get the total FCF in 2008.
Total FCF2008 $600,000 $10,300,000 $10,900,000 Step 3 Find the sum of the present values of the FCFs for 2004 through 2008
to determine the value of the entire company, VC. This calculation is
shown in Table 7.5, using present value interest factors, PVIFs, from
Appendix Table A–2.
Step 4 Calculate the value of the common stock using Equation 7.8. Substituting the value of the entire company, VC , calculated in Step 3, and the
market values of debt, VD , and preferred stock, VP, given in Table 7.4,
yields the value of the common stock, VS :
VS $8,628,620 $3,100,000 $800,000 $4,728,620 The value of Dewhurst’s common stock is therefore estimated to be
$4,728,620. By dividing this total by the 300,000 shares of common
stock that the firm has outstanding, we get a common stock value of
$15.76 per share ($4,728,620 300,000).
It should now be clear that the free cash flow valuation model is consistent
with the dividend valuation models presented earlier. The appeal of this
approach is its focus on the free cash flow estimates rather than on forecast dividends, w...
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