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