Question

Mexican Motors’ market cap is 200 billion pesos. Next year’s free cash flow is 8.6 billion pesos. Security analysts are forecasting that free cash flow will grow by 7.60% per year for the next five years.

a. Assume that the 7.60% growth rate is expected to continue forever. What rate of return are investors expecting? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

Rate of Return:_________%

b-1. Mexican Motors has generally earned about 10% on book equity (ROE = 10%) and reinvested 50% of earnings. The remaining 50% of earnings has gone to free cash flow. Suppose the company maintains the same ROE and investment rate for the long run. What will be the growth rate of earnings? (Do not round intermediate calculations. Enter your answer as a percent rounded to 1 decimal places.)

Growth Rate: ______%

b-2. What would be the rate of return? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

Rate of return:_____%

Answer 1

a. Rate of Return:
Given:

• Market capitalisation, or total price of all shares traded = 200 billion pesos
• Next year's free cash flow, as a measure of earnings = 8.6 billion pesos
• Growth = 7.60%

We can take that:

• Marcap x [Rate of return - growth] = Free cash flow
• So, 200 billion pesos x [Rate of return - 7.60%] = 8.6 billion pesos
• Rate of return - 7.60% = 8.6/200 = 0.043
• Therefore, rate of return = 0.043 + 0.076 = 0.119
• That is, rate of return = 11.90%

b1: Growth rate:
Given:

• Rate of return on book equity = 10%
• Retention ratio = 50%

We know that growth = Retention ratio x Rate of return. So:

• Growth = 5.0% [50% x 10%]

b2: Rate of Return
Assuming that Growth is 5%, Retention Ratio is 50%, Marcap is 200 billion pesos and Free cash flow (considered as earnings here) is 8.6 billion pesos:

• Marcap x [Rate of Return - Growth] = Free Cash Flow x (1-Retention Ratio)
• 200 billion pesos x [Rate of Return - 5%] = 8.6 billion pesos x (1-50%)
• Rate of return - 5% = 4.3/200 = 0.0215
• Rate of return = 0.0215 + 0.05 = 7.15%
• Rate of return = 7.15%