FREE CASH FLOW VALUATION

Jones Group Inc. is the parent company of Midwest Pipeline Inc., a mature, stable natural gas transmission pipeline company in the United States. In 1998, Jones Group established DCom Corp., a 100 percent owned subsidiary whose mandate is to install and commercialize a long-haul data communications network.

Tom Anderson, Chief Executive Officer of DCom, hires Vala and Associates to provide additional insight into capital markets and corporate finance issues. During the initial meeting in December 2000 with Jim Vala, CFA, Anderson comments:

"I do not believe the full value of DCom is reflected in the market price of Jones Group equity. I think DCom's full value can be determined using the free cash flows to the firm model."

Vala has the following notes from his initial meeting with Anderson:

The data communications network was built on existing property alongside Midwest Pipeline's transmission pipelines.

The major network construction is nearing completion and DCom's sales force is now in place

Network data traffic is expected to grow at a rate of 50 percent annually through 2003 and 15 percent annually thereafter.

Beginning in 2004, DCom's free cash flows to the firm are expected to grow at a sustainable rate of 15 percent annually.

The weighted average cost of capital for DCom is 17 percent.

The appropriate tax rate for DCom is 30 percent.

A.Calculate the total firm value of DCom at the end of year 2000, using the free cash flows to the firm (FCFF) model. (Please show all excel formulas and calculations)

B.State whether total firm value as determined by the FCFF model is appropriate to assess the value that DCom should contribute to the market price of Jones Group equity.

Provide support for your answer.