Question #115

- Assuming Patrick is correct to use free cash flow to the firm to value Fite Inc.; the value of the firm is closest to: A) 379. B) 412. C) 22. Michael Ballmer is an equity analyst with New Horizon Research. The firm has historically relied on dividend and residual income valuation models to value equity, but the firm's director of research, Doug Leads, has decided that the firm needs to incorporate free cash flow valuations into its practices. Therefore, Leads decides to send Ballmer to a seminar on free cash flow valuation. Upon his return from the convention, Ballmer is excited to share his newfound knowledge with his co-workers. Ballmer is asked to give a debriefing to New Horizon's team of equity analysts, where he makes the following statements: Statement 1: Free cash flow to the firm is the amount of the firm's cash flow that is free for the firm to use in making investments after cash operating expenses have been covered. Statement 2: Free cash flow to equity, then, is the amount of the firm's cash flow that is free for equity holders after covering cash operating expenses, working capital and fixed capital investments, interest principal payments to bondholders, and required divided payments. After discussing the calculation of free cash flow to the firm and free cash flow to equity from historical information, Ballmer proceeds to explain the major approaches for forecasting free cash flow. He focuses his discussion on forecasting the components of free cash flow as this method is more flexible. During his presentation, several of the analysts notice that the formula for forecasting free cash flow to equity does not include net borrowing. They bring this to Ballmer's attention, and he states that he will look into the formula and send out an updated presentation after the meeting. A week after the meeting, Jonathan Hodges approached Ballmer regarding two issues he had while applying free cash flow based valuations. The first issue that Hodges had was that he calculated the equity value of a firm using both free cash flow to equity based and dividend-based valuations and arrived at different values. The second issue that Hodges came across was the effect of a change in a firm's target leverage on FCFE. One of the firms that Hodges was analyzing may reduce leverage, and Hodges needs to know if this will affect his valuation.