In five years, a firm is expected to be operating in a stage of its life cycle wherein its expected growth rate is 5%, indefinitely; its required rate of return on equity is 11%; its weighted average cost of capital is 9%; and the free cash flow to equity is $5.25 per share at the end of year 5. What is its projected terminal value at that time?
yes, you need FCF of t+1, so you get 5.25(1.05)/.11-.05
3 choices are A) 51.93 B) 87.5 C) 131.25 But I still think you are right.
It’s C, the terminal value is at the end of year 4. You use the (year 4 value)*(1+5%) / (11% - 5%). What they give you ($5.25) is equal to (MV4)*(1+5%). Your terminal value is based upon the year-end prior to the beginning of perpetual growth (end of yr 4).
I think we need to add (1+g). We find terminal value for year 5 by (FCFE) * (1+g), correct?
I think so, but schwsr says B) is the right answer.
ACtually, I meant B not C "(year 4 value)*(1+5%) / (11% - 5%). " 5.25 / (.06) =87.5
It’s given $5.25 per share at the end of year 5. So, to get the value at that time (the end of year 5), we need to use FCFE in year 6 (or the end of year 6)? The current time is “the beginning of year one”, right?
Schweser is wrong as usual the end of year five value would be the year 6 FCFE: FCFE(6)/(r-g) which would be 5.25(1.05)/.06=91.875
Schweser is not wrong because you are calculating the terminal value at the END of the year BEFORE constant growth starts.
What is the question number?
#87845
McLeod81 Wrote: ------------------------------------------------------- > Schweser is not wrong because you are calculating > the terminal value at the END of the year BEFORE > constant growth starts. Well no sh!t! The first year of constant growth is year 6, not year 5. The question asks for company value at the end of year five, which involves using FCFE(6) in conjunction with the GGM to find the value at the end of year 5. Hence, Schweser is in fact wrong as usual.
“IN FIVE YEARS (not AFTER 5 years), a firm is expected to be operating in a stage of its life cycle wherein its expected growth rate is 5%, indefinitely” – The firm is “expected to be operating” in a stage of 5% constant growth. That means that beginning with the 5th year, it will be operating @ constant growth. And also: “What is its projected terminal value at that time?” It’s asking for the terminal value, NOT the value at the “end of year 5” as you put it. The terminal value is at the BEGINNING of the constant growth period, which in this case is the end of year 4, which is the beginning of year 5. I already passed this exam, and this is a very fundamental topic. On the exam, I suggest that you answer the question that’s being asked. Especially given that your calculation is not one of the choices, I think that it is very clear what the question is asking.
thanks McLeod
cfaboston28 Wrote: ------------------------------------------------------- > thanks McLeod Any time. Best of luck cfaboston.
Thank you all. It would be much easier if it asked for the terminal value at “the beginning of year 5” explicitly.
for Mcleoad81 specifically: lets draw a timeline Time0…Time1…Time2…Time3…Time4…Time5 In terms of this timeline “in five years” clearly puts us at the end of the 5th year not the beginning of it (Year 1=time0 to time1, Year2=time1 to time2, Year3=time2 to time3, Year4=time3 to time4, Year5=time4 to time5). There you have it that’s all that is needed to show that we have to multiply by 1+g to find the “projected terminal value AT THAT TIME” since that time must be time5 (or the end of year5). IN FIVE YEARS is in fact time5. Please distinguish between timeX (which are points in time) and years which are periods of time. In 5 years implies 5 periods have to pass, putting us at Time5 as I showed above. Te question then proceeds to ask the projected terminal value at that time, i.e. at time5, which means you need the time 6 FCFE. As for passing the exam, congratulations to you but I promise you that if you answered the CFA question this way you would have answered incorrectly. The other thing I can promise you is that Schweser is wrong (as usual, because Schweser sucks) and the CFA would include the correct answer which would be *(1+g). I would like to think that I also know what I am talking about since I taught these simplistic models to undergrads for three years!
adavydov7 Wrote: ------------------------------------------------------- > for Mcleoad81 specifically: lets draw a timeline > > Time0…Time1…Time2…Time3…Time4…Time > 5 > > In terms of this timeline “in five years” clearly > puts us at the end of the 5th year not the > beginning of it (Year 1=time0 to time1, > Year2=time1 to time2, Year3=time2 to time3, > Year4=time3 to time4, Year5=time4 to time5). There > you have it that’s all that is needed to show that > we have to multiply by 1+g to find the “projected > terminal value AT THAT TIME” since that time must > be time5 (or the end of year5). IN FIVE YEARS is > in fact time5. Please distinguish between timeX > (which are points in time) and years which are > periods of time. In 5 years implies 5 periods have > to pass, putting us at Time5 as I showed above. Te > question then proceeds to ask the projected > terminal value at that time, i.e. at time5, which > means you need the time 6 FCFE. > > As for passing the exam, congratulations to you > but I promise you that if you answered the CFA > question this way you would have answered > incorrectly. The other thing I can promise you is > that Schweser is wrong (as usual, because Schweser > sucks) and the CFA would include the correct > answer which would be *(1+g). I would like to > think that I also know what I am talking about > since I taught these simplistic models to > undergrads for three years! Re-read the question: “In five years, a firm is expected to BE OPERATING IN A STAGE OF ITS LIFE CYCLE wherein its expected growth rate is 5%, indefinitely; its required rate of return on equity is 11%; its weighted average cost of capital is 9%; and the free cash flow to equity is $5.25 per share at the end of year 5. What is its projected terminal value at that time?” The question does not say, “In five years, a firm is expected to START the stage of its life cycle”. It clearly says that in five years they will be IN that stage. Thus, during year five, they are in the first year of regular growth. McLeod is spot on. As for teaching these things to undergrads, awesome. Your math is right. Your comprehension is wrong.
I think it’s pretty obvious that the question is saying that the firm is operating in a state of constant growth DURING the fifth year, and not AFTER five years. That’s why they say: “IN five years, a firm is expected TO BE OPERATING IN A STAGE OF ITS life cycle WHEREIN its expected growth rate IS 5%” Can it be any more clear than that? If they meant that it was to start constant growth AFTER five years they would say: “AFTER FIVE YEARS, a firm is expected to be operating in a stage of its life cycle wherein its expected growth rate is 5%” There is a clear and concrete difference between the two, and I have seen the question worded in either format on MANY occasions. This is a VERY basic and typical question. I hate to break it to you, but CFAI isn’t going to lay it all out there for you on the real exam either. You have to be able to read between the lines.