Question

5. You are evaluating a firm’s shares which are currently sold for $22 for investment. You are using 10% of the margin of safety that is applied to the value per share. Use the following information. Last year the firm posted sales of $500 million. You expect sales to grow at 10 percent for 3 years and 8 percent for another two years before the firm matures with a sales growth rate of about 4%. Assume that the company currently has 25% operating margin which will increase to 27% in year 3 and after. Corporate tax rate and will remain at the current rate of 25%. Interest is paid at after-tax cost of debt rate of 5%. The company has $250 million debt which is a quarter of assets. Use CAPM to calculate the company’s cost of equity (Risk free rate is 2%, market risk premium is 8% and the company’s equity beta is 1.20). Capital expenditures will be 10% of sales and depreciation will be 1% of sales every year. Company also invests 0.5% of sales in expanding net working capital every year. The number of shares outstanding is 30 million. Would you invest in this stock? Solve the problem in Excel and copy-paste your tables to your word document – make sure they are organized, properly labeled and readable. (25 points)

Answer 1

Calculation of Cost to Company (Kc)
Cost of Equity (Ke) using CAPM: -
	= Rf + (Rm-Rf)B
	=2%+(8%-2%)*1.2
	9.20%
Cost of Debt post -tax	5%
Market value of: -			Weights
Debt (Quarter of assets)	250		0.25
Equity	750		0.75
	1000
Kc = KeWe + KdWd
= 9.2% * 0.75 + 5% * 0.25
= 8.15%

Free cash flow for firm (FCFF)	($ in millions)
Growth (%)	Sales			10.00%	10.00%	10.00%	8.00%	8.00%	4.00%
Proportion (%)	OM		25.00%	25.00%	25.00%	27.00%	27.00%	27.00%	27.00%
Particulars			Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
Sales			500.00	550.00	605.00	665.50	718.74	776.24	838.34
Operating Margin			125.00	137.50	151.25	179.69	194.06	209.58	226.35
Capital Expenditure (CE) (10% of sales)		A	50.00	55.00	60.50	66.55	71.87	77.62	83.83
Depreciation (1% of sales)		B	5.00	5.50	6.05	6.66	7.19	7.76	8.38
Working Capital changes (0.5% of sales)		C	2.50	2.75	3.03	3.33	3.59	3.88	4.19
Net Investment (A-B+C)			47.50	52.25	57.48	63.22	68.28	73.74	79.64
Operating Margin			125.00	137.50	151.25	179.69	194.06	209.58	226.35
Add:- Depreciation			5.00	5.50	6.05	6.66	7.19	7.76	8.38
EBIT			130.00	143.00	157.30	186.34	201.25	217.35	234.73
NOPAT [EBIT * (1-tax rate)]			97.50	107.25	117.98	139.76	150.94	163.01	176.05
Free cash flow for firm (FCFF)			50.00	55.00	60.50	76.53	82.66	89.27	96.41
(NOPAT - Net Investment)
PVF @ 8.15%				0.92	0.85	0.79	0.73	0.68
PV of FCFF for 1 to 5 years @ Kc				50.85	51.72	60.50	60.41	60.33

Value of firm at horizon period start from 6 year
Vf = FCFF6 / Kc-g
= 96.41 / 0.0815 - 0.04
= $ 2,323.1325 Million
PV of 2,323.1325 @ Kc = Vf / (1+Kc)^5
= $ 1,579.73 Million
Value of firm = 50.85+51.72+60.5+60.41+60.33+1579.73
= $ 1,863.54 Millions
Less:- Debt = $ 250 Millions
Value of Equity = $ 1,613.54 Millions
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