CFA Level II ExamEquity InvestmentsMedium
A financial analyst is valuing 'GlobalTech Solutions', a rapidly growing technology company, using the Free Cash Flow to Equity (FCFE) model. The analyst has projected the following for the next five years: current FCFE is $20 million, expected to grow at 25% for the next two years (Stage 1), then at 15% for the subsequent three years (Stage 2). After five years, the growth rate is expected to stabilize at 5% indefinitely (Stage 3). The company's required rate of return on equity is 12%. What is the value of FCFE in Year 3?
- A$48.30 million
- B$31.25 million
- C$44.92 million
- D$39.06 million
Show answer & explanationAnswer & explanation
Correct answer: D. $39.06 million
To calculate the FCFE in Year 3, we apply the Stage 1 growth rate for two years and then the Stage 2 growth rate for one year. The FCFE for Year 1 is $20 million * (1 + 0.25) = $25.00 million. The FCFE for Year 2 is $25.00 million * (1 + 0.25) = $31.25 million. The FCFE for Year 3 is $31.25 million * (1 + 0.15) = $35.94 million.
Why the other options are wrong
- A. This value incorrectly applies an incorrect growth rate or miscalculates subsequent growth.
- B. This is the FCFE for Year 2, not Year 3.
- C. This value incorrectly applies the Stage 2 growth rate from the initial $20 million, or miscalculates subsequent growth.
Multi-Stage FCFE Valuation
A valuation model that estimates the intrinsic value of equity by discounting future Free Cash Flow to Equity (FCFE) during multiple distinct growth stages, typically high growth, transition, and stable growth.
- Assumes FCFE grows at different rates over several periods.
- Commonly used for companies with varying growth prospects over time.
- Requires estimation of FCFE for each stage and a terminal value.
Memory trick: Calculate FCFE growth, stage by stage, then discount.