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a) The XYZ company is forecasting that it will generate EBIT of $30K, $40K and $50K in each of the next 3 years. Depreciation is expected to be $3K; $3.5K and $4K in each of the years of the EBIT forecast. Capital expenditures are estimated as $8K, $9K and $10K, per year over the same period. And increases in working capital are forecast as $2.5K; $3K; and 3.5K over the three years. The tax rate is 35%,
Calculate the free cash flows for each of the three years.
b) For the company XYZ as shown in (a), the cost of capital is 9 per cent. Free cash flows are expected to grow at 4 percent after year 3. Now apply the growing perpetuity formula to estimate the Terminal Value, as of year 3.
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Compute the cost of internal equity based on the Security Market Line. Compare this to the cost of equity found using the discounted cash flow model. Which, if either, do you think is more correct? Explain
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