Question

Daryll Enterprises forecasts the free cash flows (in millions) shown below. The weighted average cost of capital is 14.0%, and the FCFs are expected to continue growing at a 5.5% rate after Year 4. The company’s balance sheet shows $20 million of notes payable, $100 million of long-term debt, $60 million of preferred stock,$23 million of retained earnings, and $100 million of total common equity.

a. If the company has 15 million shares of stock outstanding, what is the best estimate of its price per share?

b. Based on the answer from (a), if the market price of the stock is observed to be $21 per share, should you long or short the stock?

Year 1 2 3 4

FCF $15 $25 $35 $45

a. Stock price= 233.356448/15=15.5571

b. We should short the stock.

Please solve and explain what formulas where used at each step! Thank you in advance!

Answer 1

Answer a:

Given:

FCF1 = $15 million

FCF2 = $25 million

FCF3 = $35 million

FCF4 = $45 million

FCFs are expected to continue growing at a 5.5% rate after Year 4.

Hence:

FCF5 = $45 * (1 + 5.5%) = $47.475 million

Terminal value at the end year 4 = FCF5 / (Cost of capital - Constant growth rate)

= 47.475 / (14% - 5.5%)

= 558.529412 million

Enterprise value at time 0 = 15 / (1 + 14%) + 25/ (1+14%)^2 + 35 / (1 + 14%) ^3 + (45 + 558.529412) / (1 + 14%)^4

= 413.356448 million

Market value of common share = Enterprise value - Notes Payable - Long term debt - Preference equity

= 413.356448 - 20 - 100 - 60

= 233. 356448 million

Best estimate of share Price = Market value of common share / Number of common shares outstanding

= 233.356448 / 15

= $15.5571

Best estimate of share Price = $15.5571

Answer b:

Given:

Market price of stock = $21

We calculated above, intrinsic value of share = $15.56

As such the stock is overvalued and you should short the share.