In: Finance
Amarindo, Inc. (AMR), is a newly public firm with 10.5 million shares outstanding. You are doing a valuation analysis of AMR. You estimate its free cash flow in the coming year to be $14.84 million, and you expect the firm's free cash flows to grow by 4.1% per year in subsequent years. Because the firm has only been listed on the stock exchange for a short time, you do not have an accurate assessment of AMR's equity beta. However, you do have beta data for UAL, another firm in the same industry:
UAL | Equity Beta =1.2 | Debt beta 0.24 | debt equity ratio 0.8 |
AMR has a much lower debt-equity ratio 0.24 which is expected to remain stable, and its debt is risk free. AMR's corporate tax rate is 35%, the risk-free rate is 5.1%, and th expected return on the market portfolio is 11.3%.
a. Estimate AMR's equity cost of capital.
b. Estimate AMR's share price.
a) We have for equity Beta
Levered equity beta = unlevered equity beta *(1+(1-tax rate)*D/E)
For UAL, assuming same tax rate
1.2 = unlevered equity beta *(1+0.65*0.8)
=> unlevered equity beta = 0.7895
So, it can be assumed that the unlevered equity beta of AMR is also 0.7895
Levered equity beta of AMR = unlevered equity beta *(1+(1-tax rate)*D/E)
=0.7895*(1+0.65*0.24)
=0.9126
So, As per CAPM
Cost of equity of AMR = Riskfree rate + Levered Equity beta * (expected market return- risk free rate)
= 5.1%+0.9126*(11.3%-5.1%)
=10.76%
So, AMR's cost of equity capital is 10.76%
b) Cost of Debt of AMR is 5.1% as it is riskfree
WACC of AMR = 0.24/(1+0.24)*5.1%*(1-0.35)+ 1/(1+0.24)*10.76% = 9.319%
As per Gordon's constant growth model
Value of Firm = next year free cashflow/ (WACC - growth rate of Cashflows)
=$14.84 million/(0.09319-0.041)
=$284.34566 million
As D/E = 0.24
Value of Equity = 1/1.24 * $284.34566 = $229.311 million
Share price = Value of equity/No of shares = $229.311 million/ 10.5 million shares
= $21.84 per share