Question

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

Year	1	2	3	4	times times times•••
FCF	1010	1212	1313	1414	Grow by 3 %3% per year

a. Covan has

88

million shares​ outstanding,

​$44

million in excess​ cash, and it has no debt. If its cost of capital is

11 %11%​,

what should be its stock​ price?

b. Covan adds its FCF to​ cash, and has no plans to add debt. 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?

a. Covan has

88

million shares​ outstanding,

​$44

million in excess​ cash, and it has no debt. If its cost of capital is

11 %11%​,

what should be its stock​ price?The stock price should be

​$nothing.

Answer 1

Solution:

a)Calculation of value of firm

Value of firm=Present value of cash flow+Present value of terminal value

Terminal value at the end of year 4=14/(0.11-0.03)=175.00

Present value of cash flows and terminal value using cost of capital of 11% as discounting rate

=10/(1+0.11)^1+12/(1+0.11)^2+13/(1+0.11)^3+14/(1+0.11)^4+175/(1+0.11)^4

=9+9.74+9.51+9.22+115.28

=152.75

Stock price=Value of firm+Cash-debt/No. of shares

=($152.75+$4-0)million/8 million

=$19.59

b)Value of firm at the begining of year 2

Thus we have to calculate the present value of cash flows from year end 2 and present value of terminal value

Value of firm=12/(1+0.11)+13/(1+0.11)^2+14/(1+0.11)^3+175/(1+0.11)^3

=10.81+10.55+10.24+127.96

=$159.56 million

Share price at the begining of year 2=($159.56 million+$4 million)/8 million

=$20.45

c)Expected return=Share price at the begining of year 2-share price at the begining of year1

=$20.45-$19.59

=$0.86