Problem 2. [30 points] One important challenge in the creation of DCF models is the estimation of growth rates and tying them into the model. How is growth in the free cash flow to the firm (FCFF) generated? Overly simplified, firms can increase their revenue while maintaining their margins (sell more of a unit without incurring additional costs), or firms can improve their margins while maintaining their revenue (sell the same number of units while making more profit on each), or both. Consider the following simplified income statement and balance sheet of a firm for 2020: Net Sales 1,000.00 Total Assets 5000.00 COGS 200.00 Cash 1000.00 Operating Costs 500.00 Operating Assets 4000.00 Operating Costs ex. D&A 420.00 Total Liabilities 2000.00 D&A 80.00 Total Equity 3000.00 Operating Income / EBIT 300.00 Interest Expenses 40.00 Taxes 65.00 Note that the tax rate is t = 25%. Net Income 195.00 The firm records capital expenditures of $ 160.00 and no changes to non-cash working capital. a) What is the free cash flow to the firm? b) What is firm's reinvestment rate, defined as Reinvestment = CapEx - D&A + Change in non cash WC EBIT(1 -t) c) What is the firm's return on capital, defined as ROC = EBIT(1 - t) BV of equity + BV of debt - Cash Just like earnings and dividends could not grow faster than b x ROE, free cash flow to the firm cannot grow faster than reinvestment times ROC. These two numbers, roughly, represent increases in revenue by growth and increases in margins, as discussed above