Question #93
Reading: Reading 21 Free Cash Flow Valuation
PDF File: Reading 21 Free Cash Flow Valuation.pdf
Page: 44
Status: Unattempted
Question
Sudbury Industries expects FCFF in the coming year of 400 million Canadian dollars ($), and expects FCFF to grow forever at a rate of 3 percent. The company maintains an all-equity capital structure, and Sudbury's required rate of return on equity is 8 percent. Sudbury Industries has 100 million outstanding common shares. Sudbury's common shares are currently trading in the market for $80 per share. Using the Constant-Growth FCFF Valuation Model, Sudbury's stock is:
Answer Choices:
A. overvalued
B. undervalued
C. fairly valued
Explanation
Based on a free cash flow valuation model, Sudbury Industries shares appear to be fairly
valued.
Since Sudbury is an all-equity firm, WACC is the same as the required return on equity of
8%.
The firm value of Sudbury Industries is the present value of FCFF discounted by using
WACC. Since FCFF should grow at a constant 3 percent rate, the result is:
Firm value = FCFF1 / WACC−g = 400 million / 0.08−0.03 = 400 million / 0.05 =
$8,000 million
Since the firm has no debt, equity value is equal to the value of the firm. Dividing the
$8,000 million equity value by the number of outstanding shares gives the estimated value
per share:
V0 = $8,000 million / 100 million shares = $80.00 per share