Question

Covan, Inc. is expected to have the following free cash? flow:

Year 1 2 3 4

FCF 11 13 14 15 Grow by 4 % per year

a. Covan has 8 million shares outstanding, $2 million in excess cash, and it has no debt. If its cost of capital is 12 %, what should be its stock price?

b. Covan reinvests all its FCF and has no plans to add debt or change its cash holdings (it does not invest its cash holdings). If you plan to sell Covan at the beginning of year 2, what is its expected? price?

c. Assume you bought Covan stock at the beginning of year 1. What is your expected % return from holding Covan stock until year 2 Your expected return from holding Covan stock until the beginning of year 2 is (?%)?

Answer 1

a….Year	1	2	3	4	Terminal Value at Year 4
FCF	11	13	14	15	195
PV F at 12%	0.89286	0.79719	0.71178	0.63552	0.63552
PV at 12%	9.82143	10.36352	9.96492	9.53277	123.92603
Total Value of Firm (V0) at Y0=NPV of FCFs= Sum PVs =
163.61
NOTE: Terminal Value at Year 4=			15*1.04/(0.12-0.04)=
			195
Stock Price P(0)=( V(0)+cash-Debt)/No.of shares o/s
ie. (163.61+2-0)/8=
20.70

b.
Expected price = the PV of future(ie. Remaining) FCFs
a….Year	2	3	4	Terminal Value at Year 3
FCF	13	14	15	195
PV F at 12%	0.89286	0.79719	0.71178	0.71178
PV at 12%	11.6071	11.1607	10.6767	138.7971
Total Value of Firm (Beg. V2) or end   Y1=NPV of FCFs= Sum PVs =
172.24
NOTE: Terminal Value at Year 4			15*1.04/(0.12-0.04)=
			195
Stock Price at end P(1) or beg. P(2)=( V10)+cash-Debt)/No.of shares o/s
ie. (172.24+2-0)/8=
21.78

c.
Expected return from holding Covan stock until the beginning of year 2 =
Beg. P(2)-Beg. P(1)=
(21.78-20.70)/20.70=
5.22%