Income approaches: You are valuing the equity of Cirona Company using the FCFE approach and have estimated that the FCFE in the next three years will grow at an 8 per cent rate from last year's FCFE of $2.1 million. Beginning in year 4, you expect the cash flows to increase at a constant rate of 5 per cent per year for the indefinite future. The cost of equity for the company is10 per cent. What is the value of equity in this company?

Question

Quizplus · Accepted Answer

To calculate the value of equity using the FCFE approach, we use the formula:
Value of equity = (FCFE1 / (1 + ke) + FCFE2 / (1 + ke)² + FCFE3 / (1 + ke)³ + (FCFE4 * (1 + g)) / (ke - g)) / (1 + ke)³
Where:
FCFE1 = Free cash flow to equity in year 1 = $2.1 million (given)
ke = Cost of equity = 10%
g = Growth rate in cash flows from year 4 onwards = 5%
FCFE2 = $2.1 million * (1 + 8%) = $2.268 million
FCFE3 = $2.268 million * (1 + 8%) = $2.44864 million
FCFE4 = $2.44864 million * (1 + 8%) = $2.64551 million
Using these values in the formula:
Value of equity = ($2.1 million / 1.1 + $2.268 million / 1.1² + $2.44864 million / 1.1³ + ($2.64551 million * 1.05) / (0.1 - 0.05)) / 1.1³ = $48 million. 
Therefore, the answer is C) $48 million.

Income Approaches: You Are Valuing the Equity of Cirona Company