Basic Stock Valuation: Free Cash Flow Valuation Model

The recognition that dividends are dependent on earnings, so a reliable dividend forecast is based on an underlying forecast of the firm's future sales, costs and capital requirements, has led to an alternative

stock valuation approach, known as the free cash flow valuation model. The market value of a firm is equal to the present value of its expected future free cash flows:

$\{\begin{array}{ccc}\text{:}[& \text{M}\text{a}\text{r}\text{k}\text{e}\text{t}\text{v}\text{a}\text{l}\text{u}\text{e}& ]\\ & of\text{c}\text{o}\text{m}\text{p}\text{a}\text{n}\text{y}& \end{array}=\frac{FC{F}_1}{(1+\text{W}\text{A}\text{C}\text{C}{)}^1}+\frac{FC{F}_2}{(1+\text{W}\text{A}\text{C}\text{C}{)}^2}+$cdots$+\frac{FC{F}_{}}{(1+\text{W}\text{A}\text{C}\text{C}{)}^{}}$

Free cash flows are generally forecasted for $5$ to $10$ years, after which it is assumed that the final forecasted free cash flow will grow at some long$-$run constant rate. Once the firm reaches its horizon date,

when cash flows begin to grow at a constant rate, the equation to calculate the continuing value of the firm at that date is:

Horizon value $=V_{\text{C}\text{o}\text{m}\text{p}\text{a}\text{n}\text{y}att}=N=FC\frac{F_{N+1}}{\text{W}\text{A}\text{C}\text{C}-g_{FCF}}$

Discount the free cash flows back at the firm's weighted average cost of capital to arrive at the value of the firm today. Once the value of the firm is calculated, the market value of debt and preferred are

subtracted to arrive at the market value of equity. The market value of equity is divided by the number of common shares outstanding to estimate the firm's intrinsic per$-$share value.

We present $2$ examples of the free cash flow valuation model. In the first problem, we assume that the firm is a mature company so its free cash flows grow at a constant rate. In the second problem whe

assume that the firm has a period of nonconstant growth.

Quantitative Problem $1$: Assume today is December $31,2019.$ Barrington Industries expects that its $2020$ after$-$tax operating income $[$EBIT$(1-$ T$)]$ will be $$430$ million and its $2020$ depreciation expense

will be $$60$ million. Barrington's $2020$ gross capital expenditures are expected to be $$120$ million and the change in its net operating working capital for $2019$ will be $$20$ million. The firm's free cash flow is

expected to grow at a constant rate of $5\mathrm{.}5\%$ annually. Assume that its free cash flow occurs at the end of each year. The firm's weighted average cost of capital is $9\%$; the market value of the company's

debt is $$2\mathrm{.}8$ billion; and the company has $190$ million shares of common stock outstanding. The firm has no preferred stock on its balance sheet and has no plans to use it for future capital budgeting

projects. Using the free cash flow valuation model, what should be the company's stock price today $($December $31,2019)?$ Do not round intermediate calculations. Round your answer to the nearest cent.

$

per share

Quantitative Problem $2$: Hadley Inc. forecasts the year$-$end free cash flows $($in millions$)$ shown below.

The weighted average cost of capital is $9\%,$ and the FCFs are expected to continue growing at a $5\%$ rate after Year $5.$ The firm has $$24$ million of market$-$value debt, but it has no preferred stock or any

other outstanding claims. There are $19$ million shares outstanding. What is the value of the stock price today $($Year $0)?$ Do not round intermediate calculations. Round your answer to the nearest cent.

$

per share

According to the developed valuation models, the value that an investor assigns to a share of stock is dependent on the length of time the investor plans to hold the stock.

The statement above is