Question

Stock Valuation

Rue Company is a great corporation going through some good times. It has never paid a dividend in the past and is not planning on ever doing so. The CFO, Dr. Rue, expects that the inflation in Europe will be higher than the one in Asia due to the recovery. The main product of Rue Co is a mechanical pencil which is made in the US and sold in South America, Europe and Asia

Recently he (Dr. Rue) was interviewed by the Partition Street Journal. When asked about the free cash flows for the current year (FCF0), Dr. Ruesaid: “The company expects that the after-tax operating income, EBIT(1-T) will be $300 million next year. The depreciation will be $45 million and given the growth prospects, capital expenditures will reach $25million. Net operating working capital will increase by $5million”. In the same interview, he said that investors should expect this FCF0 to grow by and astonishing 50% for the next 2 years, then at 25% for years 3, 4 and 5, after which FCFs are expected to grow at a boring but constant rate of 3% forever.

You searched on Bloomberg and discovered that similar companies have a WACC of 12% and you plan to use it as the discount rate in your calculations. You found out that Rue Co has $5,000 million (5 billion) in debt and $200 million in non-operating assets. The company has 500 million shares outstanding.

You want to invest in this company but you are very concerned about the results of the US election next week. Depending on who wins, you expect EBIT to fluctuate between $275m to $325m and the WACC to fluctuate between 10% to 14%. For this reason, you to have to answer the following questions before investing

1. Under the base case assumptions, what should be the current stock price for Rue Company?

2.   Complete the table below with the changes to EBIT and WACC:

Price of Rue Co under different assumptions

Price		WACC
		10%	14%
EBIT(1-T)	$275
	$325

3. Explain how EBIT(1-T) and WACC effect stock prices?

Answer 1

Formula for FCF = EBIT(1-T) + Depreciation - Capital Expenditures - Inc in working capital

= 300 + 45 - 25 + 5 = $ 325 million

Refer below table for calculation of stock price under base case assumption

Similarly calculating Share price when WACC is 10% and EBIT(1-tax)= 325 ( i.e. FCF for year 1 is 350 )

Similarly calculating Share price when WACC is 14% and EBIT(1-tax)= 275 ( i.e. FCF for year 1 is 300 )

Thus it is observed as EBIT (1- tax ) increases share price increases

And as WACC increases share price decreases