Question

A manufacturer of air filter systems for industrial facilities, is considering the addition of a new system to its current product line. The following data has been forecasted:

Years	2012	2013	2014	2015
Depreciation	30,000	35000	40000	45000
EBIT	100,000	125,000	150,000	175,000
Investment in Operating Assets	30,000	40,000	50,000	60,000

The market value of the firm's debt is $500,000 and it has $150,000 in marketable securities. The company also has 10,000 of preferred stocks that just paid an annual dividend of $0.75. Investors require a rate of return of 7% on preferred stocks of similar risk. Moreover, the firm has 200,000 shares of stock outstanding and its weighted average cost of capital is 15%. The expected tax rate is 35% in the next two years and 40% after that.

a.      Calculate the free cash flow for each of the next three years.

b.     After 2015 the firm's free cash flow is expected to grow at 5% per year indefinitely. What is the value of the stock today?

Answer 1

Solution (a)

Calculation of cash flow for each of the next 3 years

		2015	2016	2017	2018
	Debt	500000
	share of stock	200000
	Preferred stock*(working)	107143
	Equity and debt investment	807143	1774286	1784286	1794286
	Marketable securities (common stock)	150000
	Growth trend of investment in operating assets	10000	10000	10000	10000
	(60000-50000)
	Tota investment (A)	1774286	1784286	1794286	1804286
	Depreciaiton	40000	45000	50000	55000
	Growth trend of increase in Depreciation	5000	5000	5000	5000
	Net depreciation( B)	45000	50000	55000	60000
	Net investment (total investment-depreciation)	1729286	1734286	1739286	1744286
	WACC	15%	15%	15%	15%
	Cash flows	259393	260143	260893	261643
	Tax %	35%	40%	40%	40%
	Less: Tax $	-90788	104057	104357	104657
	Net cash flows	168605	364200	365250	366300
	Add : Depreciation	45000	50000	55000	60000
	Free cash flows	213605	414200	420250	426300
	Dividend on Preferred stock %	7%	7%	7%	7%
	Less: Dividend Preferred stock $	-7500	-7500	-7500	-7500
	Free cash flows for equity	206105	406700	412750	418800
	*Working
	Value of Preferred stock
	Dividend paid = 0.75
	Value per preferred stock =0.75/7% =10.7143
	value of Preferred stock =10.7143*10000 = 107143
Solution (b)	In free cash flow increase 5% per year
		2015	2016	2017	2018	Total
	Free cash flow		213605	224285.65	235499.94
	Grow %		5%	5%	5%
	Increased free cash flows		224286	235500	247275
	Less: Dividend Preferred stock $		-7500	-7500	-7500
	Increase in value of equity		216786	228000	239775
	Present value (WACC@ 15%)		0.8696	0.7561	0.6575
	Present value of cash flows		188517	172391	157652	518560
	Terminal flow (free cash flow on 2018)	239775
		Amount
	Value of Investment	1598500
	(Terminal flow/ WACC)
	Add: Present value of cash flows	518560
	Total value of investment	2117060
	Less: Debt	-500000
	Less : Preferred stock	-107143
	Net value of stock	1509917