Question

Your employer, a mid-sized 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 temporary heavy workloads. Your employer is also considering the purchase of Bigger staff & 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%. Using this information answer the following question:

You have just learned that B&M has undertaken a major expansion that will change its expected free cash flows to -10 million in 1 year, $20 million in 2 years, and $35 million in 3 years. After 3 years, free cash flow will grow at a rate of 5%. No new debt or preferred stock was added; the investment was financed by equity from the owners. Assume the WACC is unchanged at 11% and that there are still 10 million shares of stock outstanding.

(1) What is the company's horizon value (its value of operations at year3)? What is its current value of operations (at time 0)

(2) What is its estimated intrinsic value of equity on a price-per-share basis?

Answer 1

Part 1)

The horizon value (value of operations at Year 3) is calculated as below:

Horizon Value = FCF for Year 3*(1+Growth Rate for Year 3 Onwards)/(WACC - Growth Rate from Year 3 Onwards)

Using the values provided in the question in the above formula, we get,

Horizon Value = 35*(1+5%)/(11%-5%) = $612.50 million

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The current value of operations can be arrived with the use of following formula:

Current Value of Operations = FCF Year 1/(1+WACC)^1 + FCF Year 2/(1+WACC)^2 + FCF Year 3/(1+WACC)^3 + Horizon Value/(1+WACC)^3

Using the values provided in the question and horizon value calculated in the above formula, we get,

Current Value of Operations = -10/(1+11%)^1 + 20/(1+11%)^2 + 35/(1+11%)^3 + 612.5/(1+11%)^3 = $480.67 million

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Part 2)

The estimated intrinsic value of equity on a price-per-share basis is determined as follows:

Intrinsic Value of Equity on a Price-Per-Share Basis = (Value of Operations + Value of Non-Operating Assets - Value of Debt - Value of Preferred Stock)/Number of Outstanding Shares

Using the values calculated in Part 1 and information given in the question in the above formula, we get,

Intrinsic Value of Equity on a Price-Per-Share Basis = (480.67 + 100 - 200 - 50)/10 = $33.07