Zhdanov Inc. forecasts that its free cash flow in the coming year, i.e., at t = 1, will be -$10 million, but its FCF at t = 2 will be $20 million. After Year 2, FCF is expected to grow at a constant rate of 4% forever.

If the weighted average cost of capital is 14%, what is the firm's value of operations, in millions?

 

The firm's value of operations = $167 million

Step-by-step explanation

The value of the operations is actually present value of all the free cash flows.

Step 1:

Compute the present value of the free cash flows for the first two years:

Present value = Free cash flow/(1 +WACC)^t

Where t is the year in which the free cash flow occurs.

For the first two years, the present value of the free cash flows is obtained as:

PV of year 1 free cash flows = -10 million/(1 + 0.14)¹

                                                   = -8.7719 million

PV of year 2 free cash flows = $20 million/(1 + 0.14)²

                                                                              = 15.3894 million

Step 2:

Compute the terminal value of firm:

Terminal value = Year 2 free cash flow (1 +g)/(WACC - g)

Where g is the constant growth rate.

Therefore:

PV = $20 million (1 +0.04)/(0.14 - 0.04)

     = $20.8 million.

Step 3:

Compute the present value f the terminal value:

Present value = $20.8 million/(1+0.14)²

                        = $160.049 million

Step 4:

Obtain the value of operations of the firm:

Value of the operations of the firm = Present value of all the cash flows of the firm

                                                              = -8.7719 million + 15.3894 million + $160.049 million

                                                              = $166.6667 million

                                                              = $167 million.