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%.

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 were 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.

A) What is its horizon value (i.e., its value of operations at year three)? What is its current value of operations (i.e., at time zero)?

B) What is its value of equity on a price per share basis?

C) If B&M undertakes the expansion, what percent of B&M’s value of operations at Year 0 is due to cash flows from Years 4 and beyond?
Hint: use the horizon value at t = 3 to help answer this question.

Answer 1

A) Horizon Value at t=3 = FCF4 / (r-g) = FCF3 (1+g) / (r-g) = 35*(1+0.05) / (0.11-0.05) = $612.5 million

Current Value of Operations = FCF1 / (1+r) + FCF2 / (1+r)2  +  FCF3 / (1+r)3 + Horizon Value / 1+r)3

Current Value of Operations = -10 / (1.11) + 20 /  1.112 + 35 /  1.113 + 612.5 / 1.113  = -9.009 + 16.232 + 25.592 + 447.855 = $480.67 million

B)

	Value of Operations	$ 480.67	Million
+	Value of non operating assets	$ 100.00	Million
	Total Estimated value of firm	$ 580.67	Million
-	Debt	$ 200.00	Million
-	Preferred Stock	$   50.00	Million
	Estimated value of equity	$ 330.67	Million
/	Number of shares (in million)	$   10.00	Million
	Estimated Price per share	$   33.07

C) Current Value of Operations = $480.67 million

Horizon Value = $612.5 million

PV of Horizon value = 612.5 / 1.113 = 447.855

% of value due to cash flow from year 4 onwards = PV of Horizon value / Current Value of Operations = 447.855 / 480.67 = 0.9317 = 93.17%