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EXAMPLE: Company X has the following estimated earnings and investments (in millions): Year Earnings Investments 1 $10 8 2 $12 10 3 $15 12 4 $16 14 5 $16.80 14.70 Company X expects a 5% constant growth from year 5 and beyond. If the market capitalization rate is 10%, what is the value of the business expressed as the present value of free cash flows? First, calculate the free cash flows for each period given: Free cash flows = Earnings – Investments Year Free Cfs 1 $2 2 $2 3 $3 4 $2 5 $2.1 Second, determine the horizon value. Because the growth rate will be 5% from year 5 and beyond, the horizon value will be calculated as follows: (Free cash flows for year 5) ÷ ( rate of return – growth rate) = Horizon value The horizon value is therefore $42 million [$2.1 million ÷ (.10 – .05)]. This amount will be added to the year 5 cash flows and discounted at the 5-period present value factor. Third, calculate the discounted cash flows (in millions): Year 1 2 3 4 5 Cash Flows $2 $2 $3 $2 $44.1 PV factor 0.909 0.826 0.751 0.683 0.621 Total Example J Discounted CF $1.818 $1.652 $2.253 $1.366 $27.386 $34,475