You have been asked to value a firm with expected annual after-tax cash flows, before debt payments, of $100 million a year in perpetuity. The firm has a cost of equity of 10%, a market value of equity of $750 million and a market value of debt of $500 million (this is also the book value). The debt is perpetual and the after-tax interest rate on debt is 5%. The company has no non-operating activities.
a. Estimate the value of the firm and the value of the equity based upon this value.
b. Estimate the value of equity, by discounting the cash flows to equity at the cost of equity.
c. Now assume that you had been told that the market value of equity was $850 million and that all of the other information remained unchanged. Answer parts a and b, using these new values.
d. In practice, what needs to happen for the two valuation approaches (FCFF and FCFE) to give the same estimate of value?