CFA Level II ExamEquity InvestmentsMedium
An analyst is valuing a mature, stable company, 'SteadyGrowth Inc.', using the Free Cash Flow to Firm (FCFF) model. SteadyGrowth Inc. has a current FCFF of $100 million. The company is expected to grow at a constant rate of 3% indefinitely. The company's weighted average cost of capital (WACC) is 8%. What is the intrinsic value of SteadyGrowth Inc. using the one-stage FCFF model?
- A$2,060 million
- B$1,250 million
- C$1,500 million
- D$2,000 million
Show answer & explanationAnswer & explanation
Correct answer: A. $2,060 million
The one-stage FCFF model (Gordon Growth Model for FCFF) is calculated as FCFF1 / (WACC - g). First, calculate FCFF1 = Current FCFF * (1 + g) = $100 million * (1 + 0.03) = $103 million. Then, Intrinsic Value = $103 million / (0.08 - 0.03) = $103 million / 0.05 = $2,060 million.
Why the other options are wrong
- B. This would be $100 million / (0.08 - 0.03) = $100 / 0.05 = $2,000 million, if current FCFF was used directly as FCFF1, which is incorrect.
- C. Incorrect calculation.
- D. This would be $100 million / (0.08 - 0.03) = $2,000 million, which incorrectly uses current FCFF instead of next year's FCFF.
One-Stage FCFF Model
A valuation model that assumes a company's free cash flow to firm (FCFF) grows at a constant rate indefinitely, similar to the Gordon Growth Model for dividends.
- Suitable for mature companies with stable, predictable growth.
- Formula: FCFF1 / (WACC - g), where FCFF1 is next year's FCFF, WACC is the weighted average cost of capital, and g is the constant growth rate.
- Assumes WACC > g for a finite value.
Memory trick: Next year's cash, divided by WACC minus growth, gives firm's worth.