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CS Professional · Corporate Restructuring, Valuation and Insolvency · Overview of Business Valuation

Meridian Foods Ltd has projected free cash flows unchanged, but the risk-free rate in the economy rises sharply and its beta also increases. All else equal, what happens to the DCF value of the company, and why?

The DCF value falls. A higher risk-free rate and higher beta both raise the cost of equity under CAPM, which raises the discount rate, so the present value of the same projected cash flows is lower. Beta measures risk, not growth.

  1. AValue rises because a higher rate signals better returns
  2. BValue falls because the cost of equity and hence the discount rate increases, reducing the present value of the same cash flowsCorrect
  3. CValue is unchanged because cash flows are unchanged
  4. DValue rises because beta measures growth

Explanation

Under CAPM, cost of equity equals risk-free rate plus beta times market premium, so both changes raise it. A higher discount rate lowers the present value of unchanged cash flows. Unchanged cash flows do not mean unchanged value, since discounting matters.

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