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Unformatted text preview: depends on the assumptions regarding the growth of the free cash flows.
Let r indicate the appropriate cost of capital, let g represent the estimated growth rate and let t indicate
the period. The value of a firm is calculated by choosing the appropriate model:
Growth assumption Model General formula No growth Perpetuity Value = Constant growth Gordon growth model Nonconstant growth Discounted cash flow FCF
r
FCF1
Value =
rg
∞ FCF
t
Value= ∑
t=1 r The appropriate cost of capital and free cash flow depend on what you are valuing:
In the valuation of equity, the cost of capital is the cost of equity and the free cash flow is the free
cash flow to equity.
In the value of the firm, the cost of capital is the weighted average cost of capital for the firm and the
free cash flow is the free cash flow to the firm.
For example, if you are valuing the equity of a company and are assuming that the free cash flows will
grow at a constant rate indefinitely, then the appropriate formulation is:
(EQ 15) Value of equity = FCFE1
re  g with re the cost of equity. If, on the other hand, you are valuing the entire firm and are assuming that the
cash flows will grow at the rate of g1 for t1 periods and then g2 thereafter, the appropriate formulation is: 4 (EQ 16) ⎛ FCFF0 (1+g1 ) t1 (1+g2 )
⎞
⎜
(rc g2 ) ⎟
FCFF0 (1+g)
⎟
Value of the firm= ∑
+⎜
⎜
⎟
t=1
(1+rc ) t
(1+rc ) t1
⎜
⎟
⎝
⎠
t t1 where rc indicates the weighted average cost of capital. Example
Consider Lowe’s Companies’ 2005 fiscal year annual report. The following information is available from
the company’s financial statements, with dollar amounts in millions:
Source
Item
Cash flow from operations
Net income
EBIT [calculated as: $4,506 +158]
Depreciation and amortization
Other noncash adjustments
Change in working capital
Capital expenditures [calculated as: $3,379  61]
Net debt f...
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This homework help was uploaded on 02/24/2014 for the course BUS 101 taught by Professor Lipsitz during the Spring '14 term at International University.
 Spring '14
 Lipsitz
 Behavioral Finance

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