Question

The following data for 3M Corporation is for the last fiscal year ending in December of 2017

Ticker symbol: MMM

Price close at fiscal year end: $ 150.64

NAICS code: 322220

Dividend payout ratio: 39.58%

Dividend yield at fiscal year end: 2.722%

Dividends per share: $ 4.10

ROE: 41.28%

Common equity total: $ 12,048 million

Preferred stock total: 0

Long term debt total: $ 11,079 million

Interest expense: $ 180 million

P/E: 20.36

Tax rate: 29.05%

FCF/share for the next year: $ 3.935

Common shares outstanding for the next year: 609.33 million

The growth rate for free cash flow is 8.00%

Return of the S&P 500 at year end 2016 was 11.96%

U.S. 20 year treasury bond at year end was paying 2.67% (used for risk free rate)

Calculate:

1-The growth rate g

2-The cost of equity k (hint: use the CAPM formula for this)

3-The valuation of the stock using the DDM

4-Total capital

5-Weight of debt

6-Weight of equity

7-Cost of debt

8-The value of the WACC

9-The value per share using the corporate valuation model

10-Based on the DDM is the stock overvalued or undervalued and by how much

11-Based on the corporate valuation model is the stock overvalued or undervalued and by how much

Answer 1

(Note: We cannot calculate Beta from the given data and hence cost of equity cannot be derived from the given data. Hence, the solution is given based on assumption that current market price reflects the intrinsic value of the equity of the firm)

1. Growth rate, g

It is mentioned that the free cash flows to equity are expected to grow at 8%. Hence, the relevant growth rate for dividends and company value is 8%.

2. Cost of Equity

As per CAPM model, Ke = R = Rf + Beta * (Rm-Rf)

However, since beta is not given, we cannot use CAPM to find out the cost of equity.

Instead, we can use the DDM model and derive cost of equity, Ke assuming that the share price exactly represents the intrinsic market value of equity of the firm.

As per DDM, Share price, P = D1 / (Ke - g)

Ke = D1/P + g

P = $150.64 and g = 8%

Free cash flow to equity for the next year,D1, is given as $3.935

(Important Note: Since "FCF per share" is mentioned, it is assumed that this is based on profit after tax after deducting interest expense etc).

Ke = 3.935/150.64 +8% = 10.61%

Hence, cost of equity is 10.61%

3) Valuation using DDM

DDM model requires cost of equity to be known. Since we cannot calculate cost of equity without beta using CAPM model (as data is not sufficient to obtaain beta), we cannot calculate value of equity (and value of the firm) using DDM model.

4) Total capital

Total Market value of capital = Market value of equity + market value of debt

Market value of equity = Number of shares outstanding * share price = 609.33 * 150.64 = $91,789.47

Market value of debt (assuming market value data is given) = $11,079

Total capital (market value) = $91,789.47 + $11,079 = $102,869

If the given long term debt value is book value, then we can only calculate book value of capital

Book value of capital = equity capital (including retained earnings) + bv of debt = 12048 + 11079 = $23,127

It is assumed that the amount 12048 includes retained earnings.

5) Weight of debt (book value basis)

Weight of debt = Book value of debt / Book Value of firm = 11079 / 23127 = 47.91%

6) Weight of equity (book value basis)

Weight of equity = 12048 / 23127 = 52.09%

7) Cost of debt (historical)

Cost of debt = Interest expense / Book value of debt

Since debt value is assumed to be book value, cost of debt will be historical cost and not the current YTM applicable for the debt of the company

Cost of debt = 180 / 11079 = 1.62% per annum

8) Value of WACC

WACC (after-tax) = We * Ke + Wd * Kd * (1-T)

As calculated already, We = 52.09% and Wd = 47.91%

Kd = 1.62% and Ke = 10.61% and Tax = 29.05%

WACC =0.5209 * 0.1061 + 0.4791 * 0.0162*(1-0.2905) = 6.08%

Important Note: The value of WACC calculated is based on book values and not market values. Using this WACC, we can only calculate book value of the firm unless otherwise the current market values are same as book values of the firm capital.

9) Valuation using corporate valuation model.

Corporate valuation model is not any different from DDM model except that it refers to both equity and debt.

Value of firm = Value of Equity + Value of Debt

Value of firm = Market value of Equity as per DDM + Market value of Debt

Since we dont have market value of debt, we cannot calculate total value of the firm.

Alternatively, corporate valuation model can also be expressed as follows

Value of firm = FCF / (WACC - g)

Where FCF is free cash flow calculated without deducting interest expense as it is now taken care by WACC in the denominator.

However, to use this model, we should know the market value based WACC and not book value based WACC.

We cannot assume the calculated WACC as same as market value based WACC as even the growth rate in FCF itself is 8% which is greater than WACC calculated. This would lead to an infinite value as the formula will not converge to a finite value.

10) and 11) Over valued or under-valued.

Since there is not sufficient information as mentioned before, we cannot conclude above over or under valuationby the market.

So, 9