Question

Assume that you have an opportunity to buy the stock of​ CoolTech, Inc., an IPO being offered for ​$3.87 per share. Although you are very much interested in owning the​ company, you are concerned about whether it is fairly priced. To determine the value of the​ shares, you have decided to apply the free cash flow valuation model to the​ firm's financial data that​ you've accumulated from a variety of data sources. The key values you have compiled are summarized in the following​ table

Free cash flow
Year​ (t)	FCF			Other data
2020	​$750,000			Growth rate of​ FCF, beyond 2023 to infinity=5%
2021	​$890,000			Weighted average cost of capital=13%
2022	​$970,000			Market value of all debt=$2,300,000
2023	​$1,090,000			Market value of preferred stock=$920,000
				Number of shares of common stock to be issued= 1,100,000

a. Use the free cash flow valuation model to estimate​ CoolTech's common stock value per share.

b.  Judging by your finding in part a and the​ stock's offering​ price, should you buy the​ stock?

c. On further​ analysis, you find that the growth rate in FCF beyond 2023 will be 6​% rather than 5​%. What effect would this finding have on your responses in parts a and b​?

a. The value of​ CoolTech's entire company is $_______. (Round to the nearest​ dollar.)

The value per share of​ CoolTech's common stock is ​$__________. (Round to the nearest​ cent.)

b.  On the basis of your finding in part a and the​ stock's offering​ price, should you buy the​ stock?  ​(Select the best answer​ below.)

A. Yes

B. No

c. If the growth rate in FCF beyond 2023 will be 6​%​, the value of​ CoolTech's entire company will be ​$_________.

​(Round to the nearest​ dollar.)

The value per share of​ CoolTech's common stock is ​$________. ​(Round to the nearest​ cent.)

On the basis of your finding in part c and the​ stock's offering​ price, should you buy the​ stock? ​ (Select the best answer​ below.)

A. No

B. Yes

B.

Yes

Answer 1

ANSWER (a) :

~ Terminal Value as on Year 2023 = [FCF₂₀₂₃ x (1 + g)] / (WACC - g)

= ($1,090,000 x 1.05) / (0.13 - 0.05)

Terminal Value = $14,306,250

~ Value of Firm:

= $750,000/1.13¹ + $890,000/1.13²  +  $970,000/1.13³  + ($1,090,000 + $14,306,250)/1.13⁴

Firm Value = $11,475,784.48

~ Common Stock Value:

= Firm Value - Value of Debt - Value of Preferred Stock

= $11,475,784.48 - $2,300,000 - $920,000

Common Stock Value = $8,255,784.48

~ Common Stock Value Per Share:

= $8,255,784.48 / 1,100,000 shares

= $7.50

Therefore, full answer (a) =

The value of​ CoolTech's entire company is $11,475,785

The value per share of​ CoolTech's common stock is ​$7.50

ANSWER (b) :

On the basis of your finding in part a and the​ stock's offering​ price, should you buy the​ stock?

Answer : YES

Reason: The intrinsic value per share as per free cashflow valuation is $7.50 per share, and the IPO offer price is $3.87. Therefore, the stock is being offered at a cheaper rate compared to its valuation, hence it should be bought.

ANSWER (c) :

If the perpetual growth rate beyond year 2023 is 6%:

~ Terminal Value = ($1,090,000 x 1.06) / (0.13 - 0.06) = $16,505,714.29

~ Value of Firm = $750,000/1.13¹ + $890,000/1.13²  +  $970,000/1.13³  + ($1,090,000 + $16,505,714.29)/1.13⁴ = $12,824,757.12

~ Value of Common Stock Per Share = ($12,824,757.12 - $2,300,000 - $920,000) / 1,100,000 shares = $8.73 per share

Therefore, full answer (c) =

If the growth rate in FCF beyond 2023 will be 6​%​, the value of​ CoolTech's entire company will be ​$12,824,757

The value per share of​ CoolTech's common stock is ​$8.73

On the basis of your finding in part c and the​ stock's offering​ price, should you buy the​ stock? = YES.