Question

Your employer, a midsized human resources management company, is considering expansion into related fields, including the acquisition of Temp Force Company, an employment agency that supplies word processor operators and computer programmers to businesses with temporarily heavy workloads. Your employer is also considering the purchase of Biggerstaff & McDonald (B&M), a privately held company owned by two friends, each with 5 million shares of stock. B&M currently has free cash flow of $24 million, which is expected to grow at a constant rate of 5%. B&M’s financial statements report short-term investments of $100 million, debt of $200 million, and preferred stock of $50 million. B&M’s weighted average cost of capital (WACC) is 11%. Answer the following questions:

1. Use a pie chart to illustrate the sources that comprise a hypothetical company’s total value. Using another pie chart, show the claims on a company’s value. How is equity a residual claim?

2. Suppose the free cash flow at Time 1 is expected to grow at a constant rate of  forever. If , what is a formula for the present value of expected free cash flows when discounted at the WACC? If the most recent free cash flow is expected to grow at a constant rate of  forever (and ), what is a formula for the present value of expected free cash flows when discounted at the WACC?

Answer 1

Question 1: Use a pie chart to illustrate the sources that comprise a hypothetical company’s total value. Using another pie chart, show the claims on a company’s value. How is equity a residual claim?

BASE ON HYPOTHETICAL VALUE:

Total corporate value is sum of value of operations and value of nonoperating assets, based on assumption

Bonds	500000
retained earning	250000
preferred stock	250000
common stock	4000000
total market value(sum)	5000000

Debt holders have first claim because they are the owners of the company and they care only given the the fixed income in th form of interest whereas.Preferred stockholders have tthe last residual claim becasue they are considered to be the owneres of the company and they have other preferential rights over such as voting powers, decision making powers.so what ever is remaining at the end after paying every other creditors and preferance shareholders that belongs to equity shareholders.

b) Terminal value stock= expected free cashflow/ WACC-growth rate
Present Value of free cash flow= expected free cash flow/ (1+r)^2+terminal value/(1+r)
Present value of free cash flow= current free cashflow* (1+r)/(1+r)^1+ rerminal value/(1+r)