Operating Division
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Your firm would like to evaluate a proposed new operating division. You have forecasted cash
flows for this division for the next five years, and have estimated that the cost of capital is 12%.
You would like to estimate a continuation value. You have made the following forecasts for the
last year of your five-year forecasting horizon (in millions of dollars):
Year 5
Revenues 1200
Operating Income 100
Net income 50
Free cash flows 110
Book value of equity 400
a. You forecast that future free cash flows after year 5 will grow at 2% per year, forever. Estimate
the continuation value in year 5, using the perpetuity with growth formula.
b. You have identified several firms in the same industry as your operating division. The average
P/E ratio for these firms is 30. Estimate the continuation value assuming the P/E ratio
for your division in year 5 will be the same as the average P/E ratio for the comparable firms
today.
c. The average market/book ratio for the comparable firms is 4.0. Estimate the continuation
value using the market/book ratio.
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Solution Summary
This solution shows the steps, calculations, and answers all questions in the operating division scenario listed.
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This question can also be solved with the use of formulas.
a. You forecast that future free cash flows after year 5 will grow at 2% per year, forever. Estimate
the continuation value in year 5, using the perpetuity with growth formula.
Year 6 = $110 free cash flow (from above) x 1.02 ...
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