Following is a free cash flow forecast for Egon’s Paranormal Investigations Corp
ID: 445266 • Letter: F
Question
Following is a free cash flow forecast for Egon’s Paranormal Investigations Corporation. Use this information for problems 1–3.
$ millions
2002
2003
2004
2005
NOPAT
20.0
22.0
25.0
28.0
Free cash flow
(2.0)
15.0
10.0
20.0
1You expect NOPAT to grow at 3% per year and for free cash flow to be equal to NOPAT, beginning in 2006. The book value of Egon’s core operations at December 31, 2001 is $100 million and its weighted-average cost of capital is 9%.
a. Forecast Egon’s book value of core operations for 2002–2006.
b. Forecast Egon’s residual income for 2002–2006.
c. Calculate the value of Egon’s core operations as of December 31, 2001, using the residual income method.
2.
Confirm your answer to problem 1(c) by taking the present value of Egon’s forecasted free cash flows.
3.
Redo problem 1 assuming the book value of Egon’s core operations at December 31, 2001 is only $80 million.
4.
Using the zero net present value investments assumption for the perpetuity period, calculate the value of the perpetuity (terminal value) under the residual income model under the following assumptions.
In thousands, except %
Residual income in first year of perpetuity period
$10,000
Sustainable growth rate in NOPAT
2%
Weighted-average cost of capital
10%
Book value of core operations at beginning of first year of perpetuity period
$205,000
Book value of core operations at end of first year of perpetuity period
$ 217,000
Number of years in forecast horizon
7 years
$ millions
2002
2003
2004
2005
NOPAT
20.0
22.0
25.0
28.0
Free cash flow
(2.0)
15.0
10.0
20.0
Explanation / Answer
Solution :
1 a)
b)
c) Value of Egon’s core operations as of December 31, 2001 = $ 100 - $ 10.19
Value of Egon’s core operations as of December 31, 2001 = $ 89.81
d) The present value of free cash flows = 2/(1+0.09)1 + 15 / ( 1+0.09)2 + 10 / ( 1+0.09)3 + 20 / ( 1+0.09)4
The present value of free cash flows = 1.83 + 12.62+ 7.72 + 14.16
The present value of free cash flows = $ 36.33
e) If the the book value of Egon’s core operations at December 31, 2001 is only $80 million
b)
c) Value of Egon’s core operations as of December 31, 2001 = $ 80 - $ 12.152
Value of Egon’s core operations as of December 31, 2001 = $ 67.848
$ Millions 2002 2003 2004 2005 2006 NOPAT 20 22 25 28 28.84 Free cash flow 2 15 10 20 28.84 Forecasted book value of core operations 109 118.81 129.5 141.16 153.86