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

The information is insufficient for me to answer part "a", however, the solution for b,c,d,e are:

b) Expected return on stock is

CAPM: Re= Risk free rate + beta( return on market-risk free rate)

T-bill trade at discount to par at 1%, price paid= 99, first we calculate yield

yield=(100-99)/99 * 100 = 1.01%

Annual return= 1.01%* (365/91) = 4.05%

Therefore risk free rate=4.05%

Now, we use CAPM

Re= 4.05 + 0.8(10-4.05)

=4.05+4.76

=8.81%

C) Weighted average cost of capital = 0.5 * (0.06(1-0.21)) + 0.5(0.0881)

=0.0237+0.04405

=0.06775 or 6.7775%

D) Estimated free cashflow at 2020= 100,000+200,000+300,000

=$600,000

We can take perpetuity grows at 4%, return on equity is 8.81%

(600,000)/(0.0881-0.04)

=12,474,013

Value of each stock is (12,474,013/10,000)

=$1247.402

E) Total risk of his portfolio is .5*10% +1.5*30%+1*25%+20%*0.8

=5%+45%+25%+16%

Risk=76% ( Please recheck this procedure. I'm a bit doubtful with the method on Question "E" first part)

(ii) Multiply all betas=.8*.5*1.5*1=0.6

Therefore if the market goes up by 10%, Percentage return for the investor is 0.6*10%=6%