Question

Bello Plc has just released its financial results for 2018. It achieved sales of £200m, and forecast that these were expected to grow at 8% per year.

Bello Plc currently has cash on deposit of £32m, debt of £12m and has issued 15m shares. It is taxed at a rate of 25%.

You are provided with the following estimates:

EBIT is 7% of sales

Increases in both net investment and in net working capital will be 8% of any increase in sales.

The firm’s WACC is expected to be 12%.

Using a free cash flow approach, calculate a fair price for Bello Plc shares. [60%]

(b)

Comparable firms are trading in the market at an average Enterprise Value to EBIT multiple of 20, based on forecasted earnings.

In the light of this, calculate a fair price for Bello Plc shares

Answer 1

(a) Free cash flow = EBIT*(1 - tax rate) + depreciation - net investment - increase in net working capital

depreciation is not given. so it's zero.

Sales next year = current sales*(1+sales growth rate) = £200m*(1+0.08) = £200m*1.08 = £216m

EBIT next year = Sales next year*EBIT as a % of sales = £216m*7% = £15.12‬m

Increases in both net investment and in net working capital will be 8% of any increase in sales.

increase in sales = Sales next year - current sales = £216m - £200m = £16m

net investment = increase in sales*net investment as a % of sales = £16m*8% = £1.28m

Increase in net working capital = £16m*8% = £1.28m

Free cash flow next year = £15.12‬m*(1-0.25) + 0 - £1.28m - £1.28m = £15.12‬m*0.75 + 0 - £1.28m - £1.28m = £11.34m + 0 - £1.28m - £1.28m = £8.78m

Firm value = [Free cash flow next year/(WACC - sales growth rate)]/(1+WACC) = [£8.78m/(0.12 - 0.08)]/(1+0.12) = (£8.78m/0.04)/1.12 = £219.5‬m/1.12 = £195.9821428571429‬m

Equity value = Firm value - debt = £195.9821428571429‬m - £12m = £183.9821428571429m

Fair price of shares = Equity value/no. of shares = £183.9821428571429m/15m = £12.27 per share

(b) EV/EBIT multiple = EV/EBIT

EV is enterprise value.

EBIT is £15.12‬m calculated in part (a).

20 = EV/£15.12‬m

EV = £15.12‬m*20 = £302.4‬m

EV value of £302.4‬m is next year. we need its present value.

present value = EV next year/(1+WACC) = £302.4‬m/(1+0.12) = £302.4‬m/1.12 = £270m

Equity value = present value of EV + cash - debt = £270m + £32m - £12m = £290m

Fair price of shares = Equity value/no. of shares = £290m/15m = £19.33 per share