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1.
Suppose a company has a capital structure with 40% debt and 60% equity. If its after-tax cost of debt is 6% and the cost of equity is 10.5%, what is the company's weighted average cost of capital?
8.7%. (0.4 x 6%) + (0.6 x 10.5%) = 8.7%
2.
Suppose we're using a DCF model with 10 years' worth of projections for a company with a 9.5% cost of capital. We estimate that the company's free cash flow in Year 10 will be $350 million, and that its cash flow will grow at 4% in perpetuity after that. The present value of the perpetuity value will equal _______.
$2.7 billion. Step 1 is to calculate the value of the perpetuity. Plugging the values into the equation: 350,000,000 x (1 + .04) / (.095-.04) = $6,618,181,818, or $6.6 billion. Step 2 is to express the value of the perpetuity in today's dollars, using the perpetuity value as a single cash flow: $6,618,181,818 / (1.095^10) = $2,670,530,254, or $2.7 billion.
3.
As a rule, and all else being equal, the riskier a company is, the _______ its discount rate will likely be.
Higher. Also, the lower the value of its future cash flows will be, all else equal.
4.
Projecting a company's future cash flow means simply projecting current trends into the future and putting a dollar value on them.
False. This is a misleading approach. There are a lot of other variables that need to go into the calculation, such as projected costs, economic trends, and other variables. The actual work is very involved.
5.
Illini Widgets will earn $350 million in cash flow four years from now. Assuming an 8.5% weighted average cost of capital, what is that cash flow worth today?
$253 million. $350,000,000/1.085^4 = $252,550,999, or $253 million. One hint: remember that future cash flow is always going to be worth less in today's dollars, so you could have automatically eliminated the choice of $380 million.
