After year 4, the free cash flows are expected to grow at an annual rate of 5%. The weighted average cost of capital for Normaltown is 12%. If the market value of the firm’s debt is $100 million, find the total value of the firm’s equity(common stock). a. $271.20 million b. $231.43 million c. $201.81 million d. $213.00 million

b. $231.43 million

Explanation:

The computation of the total value of the firm is shown below:

But before that we need to compute the year 5 cash flow and the value of year 4 which is

Year 5 cash flow  is

= $29 million × (1 + 0.05)

= $30.45 million

Now

Value of year 4 is

= (Year 5 cash flow) ÷  (required rate - growth rate)

= $30.45 million ÷ 0.12 - 0.05

= $30.45 million ÷ 0.07

= $435 million

So, the total value of the firm is

= $10 million ÷ (1 + 0.12)^1 + $15 million ÷ (1 + 0.12)^2 + $22 million ÷ (1 + 0.12)^3 + $29 million ÷ (1 + 0.12)^4 + $435 million ÷ (1 + 0.12)^4

=  $8.9286 + $11.9579 + $15.6592 + $18.430024 + $276.4504

= $331.4260  million

The Equity value is

= $331.4260 million - $100 million

= $231.43 million

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