Question

Hot Pockets Corporation is considering going public. Managers want to estimate common stock value. The standard deviation of returns for this firm is 20%. The firm’s beta is 0.8. 3-month T-Bills currently trade at a discount to par of 1% on an annualized basis. The expected return on the stock market is 10%. There are 10,000 shares of common stock outstanding. Assume the firm’s capital structure is 50% debt, 50% common equity, the cost of debt is 6%, and the marginal tax rate for the firm is 21%.

a) What is the total risk of this firm, and what is its systematic risk?

b) What is the expected return of this stock? What is the name of the model you use to estimate it?

c) What is the Weighted Average Cost of Capital for the firm?

d) If the firm’s estimated free cash flows over the next 3 years are:

Year Estimated Free Cash Flow

2018 $100,000

2019 $200,000

2020 $300,000

and after 2020 to infinity, expected free cash flows will grow at a rate of 4% per year: (i) what is the value of its equity outstanding; and (ii) what would be the price per share?

e) (i) If an investor in Hot Pockets owns equal amounts of Hot Pockets, Nextera Energy, Southwest Airlines, and Caterpillar common stock, what will the market risk of his/her portfolio be? (Assume standard deviation of 10%, 30%, and 25%, and beta of .5, 1.5, and 1 for each of Nextera Energy, Southwest Airlines, and Caterpillar common stock.) (ii) Given the above information, what will be the percentage return on this investor’s portfolio if the market goes up 10%?

Answer 1

A-	total return	standard deviation of the company	20%
	systematick risk	Beta of the company	0.8
B-	expected return of stock - risk free rate+(market return-risk free rate)*beta	1+(10-1)*.8	8.2
	It uses capital asset pricing model
C-	after tax cost of debt	6*(1-.21)	4.74
	cost of common stock		8.2
	WACC
	source	weight	cost	weight*cost
	debt	0.5	4.74	2.37
	common stock	0.5	8.2	4.1
		WACC		6.47
D-	Year	expected cash flow
	1	100000
	2	200000
	3	300000
	4	312000
	terminal value of stock = expected free cash flow in year 4/ (WACC-growth rate)	(312000/8.2%-4%)	3804878
	Year	expected cash flow	present value of cash flow = expected cash flow/(1+wacc)^n wacc = 6.47%
	1	100000	93923.17
	2	200000	175671.4
	3	300000	246960.8
	3	3804878	3132186
	present value of equity outstanding		3648741
	value per share	3648741/10000	364.8741
e-i	market risk of portfolio
	security	weight	beta	weight*beta
	H	0.25	0.8	0.2
	N	0.25	0.5	0.125
	S	0.25	1.5	0.375
	C	0.25	1	0.25
		Beta of portfolio	sum of weight*beta	0.95
e-2	Percentage return on portfolio if market up by 10%	10*0.95	9.5