Odette’s Written Lesson
FCF VALUATION
Your employer, a mid-sized human resources management company, is considering expansion into related fields, including the acquisition of Temp Force Company, an employment agency that supplies word processing operators and computer programmers to business with temporary heavy workloads. Your employer is also considering the purchase of a Biggerstaff and Biggerstaff (B&B), a privately held company owned by two brothers, each with 5 million shares of stock. B&B currently has free cash flow of $24 million, which is expected to grow at a constant rate of 5%. B&B's financial statements report marketable securities of $100 million, debt of $200 million, and preferred stock of $50 million. B&B's WACC is 11%. Answer the following questions. Show your calculations, as appropriate, to receive partial credit.
What is free cash flow (FCF)? What is the weighted average cost of capital? What is the free cash flow valuation model?
(Answer provided on sheet)
Use B&B’s data and the free cash flow valuation model to answer the following questions.
This is the only section that you will have to enter your values to find each answer. I have provided the set formula for each question given, and I’m more than confident you will find each with ease :) As a tutor I must provide both instruction to find each question, and in this case, I went ahead and provided the answers for the big questions so you can meet your deadline. I only left you with 5 to enter values for :)
e.1. What is its estimated value of operations? (Simply enter your values and find each)
Operating Income = Revenue - Cost of Goods Sold (COGS), Labor, and day-to-day expenses
e. 2. What is its estimated total corporate value?
Total corporate value = Value of operations + marketable securities
e. 3. What is its estimated intrinsic value of equity?
Intrinsic value of equity is calculated on the basis of the net worth of company and total number of paid up equity shares.
Total Net Worth of Company/ Total No of equity shares.
e. 4. What is its estimated intrinsic stock price per share?
a. Estimate the expected earnings per share of the stock.
b. Establish a price earning multiplier (or P/E ratio).
c. Develop a value anchor and a value range.
You have just learned that B&B has undertaken a major expansion that will change its expected free cash flows to −$10 million in 1 year, $20 million in 2 years, and $35 million in 3 years. After 3 years, free cash flow will grow at a rate of 5%. No new debt or preferred stock were added, the investment was financed by equity from the owners. Assume the WACC is unchanged at 11% and that there are still 10 million shares of stock outstanding.
What is its horizon value (i.e., its value of operations at year three)?
Where,
FV = future value
P = present value of cost or benefit in monetary terms
r = the rate of discount
n = no. of periods under consideration (e.g. years)
PV (Hn) = the present value of the horizon value
What is its current value of operations (i.e., at time zero)?
Operating Income = Revenue - Cost of Goods Sold (COGS), Labor, and day-to-day expenses
What is its value of equity on a price per share basis?
VPS=Value of common equity/ # of shares outstanding
Compare and contrast the free cash flow valuation model and the dividend growth model.
Free Cash Flow Valuation Model:
In corporate finance, free cash flow (FCF) is a way of looking at a business's cash flow to see what is available for distribution among all the securities holders of a corporate entity. This may be useful to parties such as equity holders, debt holders, preferred stock holders, convertible security holders, and so on when they want to see how much cash can be extracted from a company without causing issues to its day to day operations.
The free cash flow can be calculated in a number of different ways depending on audience and what accounting information is available. A common definition is to take the earnings before interest and taxes add any depreciation & Amortization then subtract any changes in working capital and capital expenditure. A number of refinements and adjustments may also be made to try and eliminate distortions depending on the audience and their intentions.
The free cash may be different to the net income for a particular accounting period as the free cash flow takes into account the consumption of capital goods and the increases required in working capital. For example in a growing company with a 30 day collection period for receivables, a 30 day payment period for purchases, and a weekly payroll, it will require more and more working capital to finance its operations because of the time lag for receivables even though the total profits has increased. If the net income was extracted from the business it would cause cash flow problems for the business.
Dividend Growth Model:
The official description of the Dividend Growth Model is; 'A stock valuation model that deals with dividends and their growth, discounted to today.
This model assumes that the basis of the valuation of stock is:
- The Current Dividend
- Growth of the Dividend
- Required Rate of Return
It is best to describe this model by using an example. Assume that a stock is paying $2.00 per year in dividends, growing at 3.5% per year. The so-called variable item in this example is the investors required rate of return, which we will assume is 12.4%.
The formula for the Dividend Growth Model is:
Value = (Current Dividend * (1 + Dividend Growth)) / (Required Return - Dividend Growth)
Now, let's insert the assumptions for the example into this formula:
Value = ($2 * (1 + .035)) / (.124 - .035)
Value = $23.26
Now, what does this mean? Basically this means that based on the current situation (the assumptions) this stock should yield a 12.4% average annual return at a price of $23.26. You might want to look at the required rate of return example for a discussion of that piece of this puzzle.
WACC SHEET
What are the typical sources of capital that should be included in estimating weighted average cost of capital (WACC)?
Answer:
Cost of Debt Formula
Cost of Debt is the cost to the company for the use of borrowed funds to finance operations.
K=Current Market Interest Rate
T=Tax Rate
Cost of Preferred Shares Formula
Cost of Preferred Shares is the cost to the company for the use of funds generated by selling preferred shares to investors.
D=Annual Dividends
P=Market Price of Shares
F=Floatation Costs
Cost of Common Shares Formula
Cost of Common Shares is the cost to the company for the use of funds generated by issuing common shares to investors.
D=Annual Dividends
P=Market Price of Shares
F=Floatation Costs
G=Constant Growth Rate of Dividends
Cost of Retained Earnings Formula
Cost of Retained Earnings is the cost to the company for the use of funds retained from previous profits.
D=Annual Dividends
P=Market Price of Common Shares
G=Constant Growth Rate of Dividends
Should these sources be evaluated at market or book value? Explain your answer.
Answer:
Weighted Average Cost of Capital (WACC) is the average cost to a company of the funds it has invested in the assets of the company. This is composed of a possible combination of debt, preferred shares, common shares and retained earnings. All components of the cost of capital are determined at the current market rates.
Granby Foods' (GF) balance sheet shows a total of $25 million long-term debt with a coupon rate of 8.50%. The yield to maturity on this debt is 8.00%, and the debt has a total current market value of $27 million. The company has 10 million shares of stock, and the stock has a book value per share of $5.00. The current stock price is $20.00 per share, and stockholders' required rate of return, rs, is 12.25%. The company recently decided that its target capital structure should have 35% debt, with the balance being common equity. The tax rate is 40%. Calculate WACCs based on book, market, and target capital structures. Which would you use to evaluate the price of a share of stock?
Answer:
BOOK VALUE WEIGHTS
Capital Weights Cost rates Product
Debt $25.00 33.33% 4.80% 1.60%
Equity $50.00 66.67% 12.25% 8.17%
Total capital $75.00 100.00% WACC = 9.77%
MARKET VALUE WEIGHTS
Capital Weights Cost rates Product
Debt $27.00 11.89% 4.80% 0.57%
Equity $200.00 88.11% 12.25% 10.79%
Total capital $227.00 100.00% WACC = 11.36%
TARGET WEIGHTS
Capital Weights Cost rates Product
Debt NA 35.00% 4.80% 1.68%
Equity NA 65.00% 12.25% 7.96%
Total capital NA 100.00% WACC = 9.64%
Sum of the 3 WACCS = 30.77%
You have been hired by the CFO of Lugones Industries to help estimate its cost of common equity. You have obtained the following data: (1) rd = yield on the firm's bonds = 7.00% and the risk premium over its own debt cost = 4.00%. (2) rRF = 5.00%, RPM = 6.00%, and b = 1.25. (3) D1 = $1.20, P0 = $35.00, and g = 8.00% (constant). You were asked to estimate the cost of common based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates. What is that difference?
Answer:
Bond Yield Plus Risk Premium = 7% + 4% = 11%
CAPM = Rf + Rpm * Beta
CAPM = 5% + 6%*1.25 = 12.5%
DCF (we need to do some rearranging to solve this one);
P0 = D1/(r-g)
35 = 1.2 / (r - 0.08)
35 * (r - 0.08) = 1.20
r - 0.08 = 1.2 / 35
r = (1.2 / 35) + 0.08 = 11.4285%
Highest is CAPM at 12.5%
Lowest is Bond Yield Plus Risk Premium at 11%
Difference is 1.5%