Determine the enterprise value of a firm whose expected operating free cash flows are $100 each year and are growing with GDP at 2.5%. Assume its weighted average cost of capital is 7.5% annually.

Determine the enterprise value of a firm whose expected operating free cash flows are $100 each year and are growing with GDP at 2.5%. Assume its weighted average cost of capital is 7.5% annually.
A . $4,000
B . $1,000
C . $1,333
D . $2,000

Answer: D

Explanation:

The operating free cash flows can be considered a perpetual annuity with a given growth rate.

The value of a perpetuity of a periodic cash flow of ‘c’, with a discount rate ‘r’ and growth rate ‘g’ is given by c/(r – g). In the given case, the company can be considered as providing a perpetual annuity which provides an annual cash flow of $100 which are growing at 2.5% (equal to the GDP’s growth rate, as given), and whose cost of capital, or the discount rate to use, is 7.5%

Therefore the value of the firm in this case is given by $100/(7.5% – 2.5%) = $2,000. Recall that the value of the firm is equal to the Operating Free Cash Flow/Weighted Average Cost of Capital (OFCF/WACC). Therefore Choice ‘d’ is the correct answer.

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