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1.
Suppose Company A has a long history of profitability, and its outlook is stable, and Company B has yet to make a profit in its short history, and its outlook is much more uncertain. Company A's cost of equity should be _______.
Less than that of Company B. This is because estimated cash flow in the future from Company A is much more certain than it is from Company B. Risk and assumed cost of equity (the return equity investors require) should be concurrent. Lower risk should mean a lower cost of equity assumption, and vice versa.
2.
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.
3.
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.
4.
What is the basic idea behind discounted cash flow?
A stock's worth is equal to the present value of all its estimated future cash flows. Discounted cash flow is ultimately what analysts use to identify a stock's intrinsic value.
5.
For the purpose of discounting a company's future cash flows, the term "cost of capital" means _______.
The rate used to discount the company's future cash flows backward to the present. The math will explain how it figures into the cash flows.
