Question

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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 state-ments 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%.

Answer the following questions:

a. Describe briefly the legal rights and privileges of common stockholders.

b. What is free cash flow (FCF)? What is the weighted average cost of capital? What is the free cash flow valuation model?

c. Use a pie chart to illustrate the sources that comprise a hypothetical company’s total value. Using another pie chart, show the claims on a company’s value. How is equity a residual claim?

d. Suppose the free cash flow at Time 1 is expected to grow at a constant rate of gL forever. If gL cash flows when discounted at the WACC? If the most recent free cash flow is expected to grow at a constant rate of gL , WACC), what is a formula for the present value of expected free cash flows when discounted at the WACC?

e. Use B&M’s data and the free cash flow valuation model to answer the following questions:

(1) What is its estimated value of operations?

(2) What is its estimated total corporate value? (This is the entity value.)

(3) What is its estimated intrinsic value of equity?

(4) What is its estimated intrinsic stock price per share?

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Answer 1

a. Legal rights and privileges of common stockholders.
Common Stockholders are viewed as the true owners of the company. All common shareholders have the right to participate in the company's profit for as long as they own the shares. Common stockholders can also influence a company's management by their voting rights and if the company issue new shares to the public, current shareholders have the right to buy shares before they are offered.

b. What is free cash flow (FCF)? What is the weighted average cost of capital? What is the free cash flow valuation model?
Free cash flow is the cash a company produces through its operation, less the cost of expenditure on capital assets. In other words, free cash flow refers to the cash available after meeting all the operating expenses, taxes, and capital expenditure.
Free cash flow (FCF)= Operating cash flow - Capital expenditures.

The weighted average cost of capital is the rate that a company is expected to pay to finance its assets, growth and working capital. In other words it refers to the minimum required rate of return which a company must earn, this is the least rate of return which a company should earn for its survival.

In free cash flow valuation, the intrinsic value of a company equals the present value of its free cash flow, the net cash flow left over for distribution to stockholders, and debt-holders in each period.
The free cash flow valuation model is when the growth rate is constant forever.

where FCFF1 = free cash flow to firm expected next year
WACC = weighted-average cost of capital
g = growth rate of FCFF

c. Use a pie chart to illustrate the sources that comprise a hypothetical company’s total value. Using another pie chart, show the claims on a company’s value. How is equity a residual claim?
I don't have any option to draw a pie chart here, so I am providing you with the data.
Bonds = 300,000
Common Stock = 2,400,000
Preferred Stock = 150,000
Retained Earnings = 150,000
Total Market Value = 3,000,000
Debt 10%
Equity 90%
Total 100%

Debt 300,000 (10%)
Equity 2,700,000 (90%)
Total 3,000,000 (100%)
Equity is the residual claim because the dividend is distributed after all the fixed financial commitments are distributed.
Also, in the case of liquidation equity shareholders are paid at the last.

d. Suppose the free cash flow at Time 1 is expected to grow at a constant rate of gL forever. If gL cash flows when discounted at the WACC? If the most recent free cash flow is expected to grow at a constant rate of gL , WACC), what is a formula for the present value of expected free cash flows when discounted at the WACC?
Terminal value stock= (Expected FCFF * (1+g)) / (WACC - g)
Present value of FCFF= (Expected FCFF/ (1+r)^1)+ Terminal value/(1+r)
Present value of FCFF= FCFF* (1+r)/(1+r)^1+ Terminal Value/(1+r)

e. Use B&M’s data and the free cash flow valuation model to answer the following questions:
Free Cash Flow = 24,000,000
WACC = 11%
Growth rate (g) = 5%
Short term investments = 100,000,000
Debt Capital = 200,000,000
Preferred Stock = 50,000,000
Total No. of Outstanding Shares = 5,000,000 + 5,000,000 = 10,000,000

(1) What is its estimated value of operations?

Value of the Firm = 24,000,000 *(1+0.05) / (0.11 - 0.05)
= $ 420,000,000

(2) What is its estimated total corporate value? (This is the entity value.)
Total Value of the Firm = 420,000,000 + 100,000,000
= $ 520,000,000

(3) What is its estimated intrinsic value of equity?
Equity Value of the Firm = Total value of the firm - Total Debt - Total preferred Stock
= $ 520,000,000 - 200,000,000 - 50,000,000
= $ 270,000,000

(4) What is its estimated intrinsic stock price per share?
Equity Value per share = 270,000,000 / 10,000,000
= $ 27