Question #40

If the growth rate in the stable-period is too high or the high-growth and transition periods are too long, the three-stage FCFE model might result in an extremely high value. (Module 21.5, LOS 21.j) An analyst has prepared the following scenarios for Schneider Inc.: Scenario 1 Assumptions: Tax Rate is 40%. Weighted average cost of capital (WACC) = 12.0%. Constant growth rate in free cash flow (FCF) = 3.0%. Year 0, free cash flow to the firm (FCFF) = $30.0 million Target debt ratio = 10.0%. Scenario 2 Assumptions: Tax Rate is 40.0%. Earnings before interest and taxes (EBIT), capital expenditures, and depreciation will grow at 20.0% for the next three years. After three years, the growth in EBIT will be 2.0%, and capital expenditure and depreciation will offset each other. Weighted average cost of capital (WACC) = 12.0% Target debt ratio = 10.0%. Scenario 2 FCFF (in $ millions) Year 0 Year 1 Year 2 Year 3 Year 4 EBIT $45.00 $54.00 $64.80 $77.76 $79.70 Capital Expenditures 18.00 21.60 25.92 31.10 Depreciation 12.00 14.40 17.28 20.74 Change in Working Capital 6.00 6.30 6.60 7.20 7.20 FCFF 18.90 23.64 29.09 40.62 Other financial items for Schneider Inc.: Estimated market value of debt = $35.0 million Cost of debt = 5.0% Shares outstanding = 20 million.