Question

Please explain each part of this 4 part question!

1. In your own words, in as much detail as is needed to show full comprehension, describe (i) the components of Equation 1, below and (ii) the purpose of the equation. (This part is worth 2.5 points.) Equation 1 Free Cash Flow, (1 + Weighted Average Cost of Capital) 2. In your own words, in as much detail as is needed to show full comprehension, describe (i) the components of Equation 2, below and (ii) the purpose of the equation. (This part is worth 2.5 points.) Equation 2 Interest Principal, (1 + Interst Rate)'(1 + Interst Rate)" 3. In your own words, in as much detail as is needed to show full comprehension, describe (i) the components of Equation 3, below and (ii) the purpose of the equation. (This part is worth 2.5 points.) Equation 3 Dividend, (1 + Required Return) Terminal Value, (1 + Required Return)" 4. In your own words, in as much detail as is needed to show full comprehension, describe what Equations 1, 2 and 3 have in common. (This part is worth 2.5 points.)

Answer 1

1]

(i)

t is the number of years after which the cash flow occurs.

n is the final year of cash flow.

Free cash flow is the cash flow to the firm, which is calculated as (net income + non cash expenses - change in working capital - capital expenditure).

WACC is the cost of capital, calculated = (weight of debt * cost of debt) + (weight of preferred stock * cost of preferred stock) + (weight of equity * cost of equity).

(ii)

The purpose of the equation is to calculate the firm value, or enterprise value.

2]

(i)

t is the number of years after which the cash flow occurs.

n is the final year of cash flow.

Interest is the yearly interest paid.

Interest rate is the required return, or discount rate.

Principal is the amount payable at the end of the period.

(ii)

The purpose of the equation is to calculate the value of a bond.

3]

i]

t is the number of years after which the cash flow occurs.

n is the final year of cash flow.

Dividend is the yearly dividend.

Required return is the return required by equity investors.

Terminal value is the horizon value, or the value of future perpetual dividends at the terminal year.

ii]

The purpose of the equation is to calculate the value of a share using the dividend discount model.

4]

The common factor between the three equations is to find the present value of a future stream of cash flows at the given discount rate. The discount rate is the WACC in the first equation, the yield of the bond in the second equation, and the shareholder's required return in the third equation. The cash flows are the free cash flows to the firm in the first equation, the interest and principal payments of the bond in the second equation, and the dividends in the third equation.