Mar/Jun 2018 Q1 Chikepe

You would get some credit for this, but the problem (and the reason your answer would not be correct) is that although the FCF will grow at 5.6% after year 4, the FCFE will not grow at a constant rate.

Dear John, I have the same quiestion, refer to c i). BPP answer as follows: FCFF = 167.6 then estimated value by using growth model is 2466.1 and finally 40% of estimated value is 986.4 - equity value My answer: FCFF=167.6 Less interest paid 78.6 so FCFE = 89 then use growth model 89*1.03/(0.1-0.03)=1309.6 equity value Results are different. Please tell me why my approach can not be used, if so. And one more question: why we cant use tax figure 22.7 (given in scenarion) in arriving FCFF? Thanks

The question speficially says that "Chikepe estimates equity values using the the free cash flow to the firm method". When calculating the free cash flow to the firm, we never include interest (just as we never include it in normal NPV calculations) because the after tax cost of debt is taken into account in the calculation of the WACC - to include it in the cash flows would be accounting for it twice. The tax of 22.7 in the SOPL is calculated on the profits after interest. Because we not bringing in the interest cash flows we need to use the tax on the profits before interest. (Again the tax saving that results from the interest is accounted for by the fact that we use the after-tax cost of debt in the WACC calculation)

Thank you John for detailed explanation, all well noted, also I will be more careful in reading scenario.

You are welcome :-)