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1.
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.
2.
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.
3.
Assume a company had $1 billion in free cash flow last year, and it is expected to grow that cash flow at 3% into perpetuity. Assuming a 9% cost of equity, what is the value of the company?
$17.2 billion. All we need to do is plug the assumptions into our perpetuity formula: ( $1 billion x (1 + .03) ) / (.09 - .03) = $17.2 billion.
4.
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.
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.
