A company forecasts growth of 6% for the next five years and 3% thereafter.Given last year's free cash flow was $100,what is its horizon value if the company cost of capital is 8%?

Question

Quizplus · Accepted Answer

To calculate the horizon value, we need to determine the present value of all the free cash flows beyond the five-year forecast period. Here's how we can do it:

1. Calculate the free cash flow for each of the next five years based on the forecasted growth rate of 6%.

Year 1: FCF = $100 x 1.06 = $106 
Year 2: FCF = $106 x 1.06 = $112.36 
Year 3: FCF = $112.36 x 1.06 = $119.10 
Year 4: FCF = $119.10 x 1.06 = $126.25 
Year 5: FCF = $126.25 x 1.06 = $133.82

2. Calculate the terminal value (TV) at the end of the five-year period. This represents the present value of all free cash flows beyond year 5, using the perpetual growth model:

TV = Year 6 FCF / (r - g) 
where r is the discount rate (8% in this case) and g is the long-term growth rate (3%).

Year 6 FCF = $133.82 x 1.03 = $137.98 
TV = $137.98 / (0.08 - 0.03) = $2,755.60

3. Calculate the present value of the terminal value using the discount rate of 8% and the number of years to the terminal value (1 year):

PVTV = TV / (1 + r)^n 
where n is the number of years to the terminal value.

PVTV = $2,755.60 / (1 + 0.08)^1 = $2,549.63

4. Calculate the total horizon value by adding the present value of the free cash flows from years 1-5 and the present value of the terminal value:

Horizon Value = PV of FCFs (Years 1-5) + PVTV 
Horizon Value = $106 / (1 + 0.08)^1 + $112.36 / (1 + 0.08)^2 + $119.10 / (1 + 0.08)^3 + $126.25 / (1 + 0.08)^4 + $133.82 / (1 + 0.08)^5 + $2,549.63 
Horizon Value = $2,676

Therefore, the correct answer is D) $2,676.

A Company Forecasts Growth of 6% for the Next Five