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Cash Flow Valuation Model

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Discuss the free cash flow model, the adjusted present value model, and the residual income model.

Provide an example of a situation where each model would be applicable. IN 4-5 paragraphs

Objective is to discuss the concepts and methods underlying the valuation of companies, including both profitability and risk analysis.

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Free cash flow model:

The Free Cash Flow DCF Model takes consideration of discounting dividend cash flows, the free cash flow model discounts the total cash flows that would flow to the suppliers of the firm's capital. Once the present value of those cash flows are determined, liabilities and preferred stock (if any) are subtracted to arrive at the present value of common stockholders' equity.

Free cash flows to investors (debt and equity) are calculated as follows:

Cash Revenue
-Cash Expenses
= Earnings before Interest, taxes, depreciation and amortization
-Depreciation & Amortization
=Earnings before Interest and taxes
-Taxes
= Net operation profit after tax
+Add back depreciation and amortization
-Capital Expenditures
-New Net working capital
= Free Cash Flow

Free cash flow represents those amounts in each operating period that are "free" to be distributed to the suppliers of the firm's capital, that is, the debt holders, the preferred stockholders, and the common stockholders

Example/Appropriate scenario: Unquoted firms (those firms which have are not listed in the stock exchange market) can be done by the use of Free Cash flow discount model.

source: http://cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page23.htm

Adjusted present ...

Solution Summary

The free cash flow model, adjusted present value model, and residual income model are discussed in this solution in 768 words with many references.

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Valuation

Calculating a company's firm price via the free cash flow model and via the residual income model. Please show work in Excel spreadsheet. Thank you!

Assume Co. began operations on January 1, 2001 with $100 cash and $100 equity. On January 1, it purchased a machine for $60 cash and inventory for $40 cash. During 2001 it sold half the inventory for $50 cash. On December 31, it purchased $30 more inventory in cash and paid a $10 dividend.

During 2002 the company sold inventory costing $40 for $70 cash. It purchased $20 more in inventory and paid out a $10 dividend.

During 2003, it sold the remaining inventory for $60 cash. At the end of 2003, the machine had no further value and was scrapped. Co. decided to cease operations and to pay out a liquidating dividend equal to cash on hand. Please ignore the effect of income taxes.
I. Assuming that the machine is depreciated on a straight-line basis over 3 years with no salvage value, calculate the following (show your work):

2001 2002 2003 Beginning equity Net income Dividends Ending equity Residual income
Assume that on January 1, 2001 you were able to forecast Co.'s future transactions perfectly.
(a) Calculate the firm's price as of January 1, 2001 using the free cash flow model. Use a 10% discount rate (cost of capital).

(b) Calculate the price using the Residual income model. Use a 10% cost of capital. You should get the same price as in (a).

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