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 COGS Operating Costs Operating Costs ex. D&A D&A Operating Income / EBIT Interest Expenses Taxes Net Income	$ $ $ $ $ $ $ $ $	1,000.00 200.00 500.00 420.00 80.00 300.00 40.00 65.00 195.00		Total Assets $ 5000.00 Cash $ 1000.00 Operating Assets $ 4000.00 Total Liabilities $ 2000.00 Total Equity $ 3000.00 Note that the tax rate is = 25%.
			1

Name: _______________________________________

The firm records capital expenditures of $ 160.00 and no changes to non-cash working capital.

1. What is the free cash flow to the firm?

2. What is firms reinvestment rate, defined as

& +

= (1 ) ?

3. What is the firms return on capital, defined as

(1 )

=?

+

Just like earnings and dividends could not grow faster than , 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.

4. What is your expectation for the FCFF of the firm in 2021?