Question

You are asked to evaluate Rising Star Co. using the free cash flow valuation approach. You have collected the following information:

Rising Star has net income of $250 million, depreciation of $90 million, capital expenditures of $170 million, and an increase in working capital of $40 million. Rising Star will finance 40% of the increase in net fixed assets (capital expenditures less depreciation) and 40% of the increase in working capital with debt financing. Interest expenses are $150 million. The current market value of Rising Star’s outstanding debt is $1,800 million. Free cash flow to the firm (FCFF) is expected to grow at 6.0% indefinitely, and free cash flow to equity (FCFE) is expected to grow at 7.0%. The tax rate is 30%. Rising Star is financed with 40% debt and 60% equity. The before-tax cost of debt is 9%, and the cost of equity is 13%. Rising Star has 10 million outstanding shares. The current price of the stock is $310.

Required:

a. Using the FCFF valuation approach, estimate the total value of the firm, the total market value of equity, and the per - share value of equity .

b. Using the FCFE valuation approach, estimate the total market value of equity and the per share value of equity .

c. Comment on the valuation. Would you recommend buying this stock ?

Answer 1

(a)

Value of the Firm =

FCFF0 = Current Free cash flow to firm

g = Growth rate

WACC = weighted avg cost of capital

FCFF = Net income+Depreciation+Interest *(1-taxrate)-Capital expenditure -change in working capital

Interest = $150 Million

FCFF = $250 million+$90 million+$150 Million*(1-0.30)- $170 million-$40 million = $235 Million

WACC = [Cost of equity * Weight of equity]+[ pretax cost of debt *(1-Tax rate)* weight of debt]

=>WACC=[13%*60%] + [9%*(1-0.30)*40%] = 7.8% +2.52% = 10.32%

growth or g in Free cash flow to the firm (FCFF) = 6%

hence,

Value of the Firm =

=> Value of the Firm = $5766.20 Million

value of the Firm = value of equity+value of debt

=> Value of Equity = Value of firm-Value of debt

=>Value of Equity=$5766.20 Million- $1,800 million =$ 3966.20 million

Rising Star has 10 million outstanding shares.

value per share = Total value of equity/ Number of shares outstanding

=>value per share=$3966.20 million/ 10 million shares = $396.62

total value of the firm= $5766.20 Million

Fair value of equity=$ 3966.20 million

per - share value of equity=$396.62

Market value of equity = Market rice per share * Number of shares outstanding=$310.*10 million outstanding shares=$3100 Million.

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(b)

Free cash flow to equity(FCFE)=

NI = Net income

NWC = net working capital change

D = debt financing

Free cash flow to equity(FCFE)=

=>FCFE = $178 Million

value of Equity =

Ke = cost of equity=13%

hence Fair value of equity =

=> Fair value of equity= $3174.333 million

Rising Star has 10 million outstanding shares.

value per share = Total value of equity/ Number of shares outstanding

=>value per share=$3174.333 million/ 10 million outstanding shares.

=>value per share=$317.43

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(c)

In both the FCFF and FCFE method the fair value of the equity is nore than the current market price.

Hence the current market price is Undervalued and it will increase in future.

Hence buying this stock will be recommended.