Question

​Covan, Inc. is expected to have the following free cash​ flow:

Year	1	2	3	4	times times times•••
FCF	10	12	13	14	Grow by 5%per year

a. Covan has 8 million shares​ outstanding, ​$3 million in excess​ cash, and it has no debt. If its cost of capital is 13%​, what should be its stock​ price? (round to nearest cent)

b. Covan adds its FCF to​ cash, and has no plans to add debt. If you plan to sell Covan at the beginning of year​ 2, what is its expected​ price? (round to nearest cent)

c. Assume you bought Covan stock at the beginning of year 1. What is your expected return from holding Covan stock until year​ 2? (round to one decimal place)

Answer 1

a). Firm Value = [FCF1 / (1 + r)] + [FCF2 / (1 + r)²] + [FCF3 / (1 + r)³] + [FCF4 / (1 + r)⁴] + [{FCF4 * (1 + g)} / {(r - g) * (1 + r)⁴}]

= [10 / (1 + 0.13)] + [12 / (1 + 0.13)²] + [13 / (1 + 0.13)³] + [14 / (1 + 0.13)⁴] + [{14 * (1 + 0.05)} / {(0.13 - 0.05) * (1 + 0.13)⁴}]

= 8.85 + 9.40 + 9.01 + 8.59 + 112.70 = $148.54 million

Share Price = [Firm Value + Cash - Debt] / Shares Outstanding

= [148.54 + 3 - 0] / 8 = 151.54 / 8 = $18.94259353

b). Firm Value = [FCF1 / (1 + r)] + [FCF2 / (1 + r)²] + [FCF3 / (1 + r)³] + [FCF4 / (1 + r)⁴] + [{FCF4 * (1 + g)} / {(r - g) * (1 + r)⁴}]

= [12 / (1 + 0.13)] + [13 / (1 + 0.13)²] + [14 / (1 + 0.13)³] + [{14 * (1 + 0.05)} / {(0.13 - 0.05) * (1 + 0.13)³}]

= 10.62 + 10.18 + 9.70 + 127.35 = $157.85 million

Share Price = [Firm Value + Cash - Debt] / Shares Outstanding

= [157.85 + 3 - 0] / 8 = 160.85 / 8 = $20.11

c). Return = [Share Price₂ - Share Price₁] / Share Price₁

= [$20.11 - $18.94] / $18.94 = $1.17 / $18.94 = 0.0614, or 6.1%