CFA Level II ExamEquity InvestmentsMedium
An analyst is performing a valuation of 'EcoSolutions Inc.', an established company in the environmental services sector. The analyst has projected the company's Free Cash Flow to Firm (FCFF) for the next three years as follows: Year 1: $150 million, Year 2: $180 million, Year 3: $210 million. After Year 3, FCFF is expected to grow at a constant rate of 4.0% indefinitely. The company's weighted average cost of capital (WACC) is 9.0%. What is the terminal value of EcoSolutions Inc. at the end of Year 3?
- A$4,200 million
- B$4,368 million
- C$4,410 million
- D$4,586 million
Show answer & explanationAnswer & explanation
Correct answer: B. $4,368 million
The terminal value (TV) at the end of Year 3 is calculated using the Gordon Growth Model with the FCFF for Year 4. FCFF4 = FCFF3 * (1 + g) = $210 million * (1 + 0.04) = $218.4 million. TV3 = FCFF4 / (WACC - g) = $218.4 million / (0.09 - 0.04) = $218.4 million / 0.05 = $4,368 million.
Why the other options are wrong
- A. This results from using FCFF3 / (WACC - g) directly, without growing FCFF3 by (1+g).
- C. This results from using FCFF3 * (1+g) as the numerator, but using WACC as the denominator, not (WACC-g).
- D. This results from an incorrect calculation of FCFF4 or an error in the denominator.
Terminal Value (FCFF Model)
The present value of all free cash flows to the firm beyond the explicit forecast period, typically calculated using a perpetual growth model.
- Calculated at the end of the explicit forecast period (e.g., Year 3).
- Uses the first cash flow *after* the forecast period (e.g., FCFF4).
- Discounted back to the valuation date to find its present value.
Memory trick: Future Cash Flows Forever, Discount Them Back!