This is a question i heard from my friend on Corp Fin topic( Schweser question)
Gambit Enterprises is being evaluated as an acquisition target. An analyst believes that the firm will have free cash flow (FCF) of $500m during year 5, after which the growth rate in FCF is expected to be 4% indefinitely. The weighted average cost of capital (WACC) for Gambit is 10%. What is the estimated value of the firm at the end of year 5?
Solution:
Value at end of year 5 = (FCF year 5 × (1 + g)) / (WACC – g) Value at end of year 5 = (500 × 1.04) / (0.10 – 0.04) = $8667m
Why is the 5th year FCF of 500 not added to the “estimated value of the firm at end of year 5” Isn’t it true that what ever a company earns in that particular year ( beginning, middle or at the end) all treated as Cash flows at the end of the year ?
This was a total shocker to me as to why the $500M was not added.
Thank you for your response in advance.
why would you need to add the $500 to the $8667? The $8867 is the estimated valuation of the firm, whereas the $500 is just the FCF it has at the end of the year. The valuation is calculated based on the FCF, you don’t add it back in again afterwards. What happens to the $500 is they take it and reinvest it into the firm and the firm grows at 4% forever (perpetually). The $500 is ‘used’ inorder to grow at 4%, otherwise, how else is the firm going to get $500 to fund it’s 4% growth?
If you had $1, and someone said he will sell you an apple and by the end of the day, it’ll grow in value by 25% for sure. You buy the apple and at the end of the day, the value of the apple becomes $1.25. What happened to the $1?
Nice alanfung86
You are mixing inflow with outflow. 500 is the inflow at year end five which will keep on growing at 4%. Considering the WACC of 10% $8867 is the amount which you should invest to get yourself that cash flow available of 500.
Clean Explanation. Thanks Alanfung86 ! now understand it…