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1.
Fictional company Mobar is expected to generate $125 million per year over the next three years in free cash flow. Assuming a discount rate of 10%, what is the present value of that cash flow stream?
$311 million. The cash flow stream would look like this: 125.00 x 0.9090 = 113.63; 125.00 x 0.8264 = 103.30; 125.00 x 0.7513 = 93.91. The sum of the three is $310.84, or $311 million.
2.
If we were to increase a company's cost of equity assumption, what would we expect to happen to the present value of all future cash flows?
A decrease. Raising the company's cost of equity assumption would lower the present value of all future cash flows.
3.
Assume you have created a DCF model that estimates a company's value to be $50 per share, but the stock trades at $90 per share. The stock is _______.
Overvalued. Because the stock trades above its estimated fair value, the stock is overvalued, and we should probably not buy the shares. Being able to compare a stock's market price to its fair value is where the effort put into creating the DCF pays off.
4.
A company's future cash flow can be determined exactly.
False. Future cash flow can never be determined exactly. At best, it can be estimated based on a number of financial and economic factors.
5.
Let's assume Mobar has just made an investment that will reduce its required capital expenditures in Year 4. All else equal, what should we expect Mobar's free cash flow to do in that year?
Increase. Recall that free cash flow is defined as operating cash flow minus capital expenditures. Lower capital expenditures mean higher free cash flow. Remember, an important part of creating any DCF model is anticipating future changes to a company's free cash flow.
