Question

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.

Answer 1

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