Question

Mexican Motors’ market cap is 360 billion pesos. Next year’s free cash flow is 9.9 billion pesos. Security analysts are forecasting that free cash flow will grow by 8.90% per year for the next five years.

a. Assume that the 8.90% growth rate is expected to continue forever. What rate of return are investors expecting? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

b-1. Mexican Motors has generally earned about 12% on book equity (ROE = 12%) and reinvested 50% of earnings. The remaining 50% of earnings has gone to free cash flow. Suppose the company maintains the same ROE and investment rate for the long run. What will be the growth rate of earnings? (Do not round intermediate calculations. Enter your answer as a percent rounded to 1 decimal places.)

b-2. What would be the rate of return? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

Answer 1

Answer;

Part A

Present value of cash flow perpetuity

= cash flow 1 / required return - growth

Cash flow 1 = 9.9 billion

Present value of investment = 360 billion

Growth = 8.9 %

Rate of return =?

So,

360 = 9.9 / R - 8.9%

360R - 32.04 = 9.9

360 R = 9.9 + 32.04

360R = 41.94

R = 41.94 / 360

R = 11.65 %

Answer parr 2

Growth rate = Return on equity x retention ratio

Return on equity = 12%

Retention ratio = 50%

Growth = 12% x .5

Growth = 6%

Part 3

Rate of return = D1 / market value + required growth

Total dividend in next year= 9.9 billion x 50% =4.95 billion

Market value = 360 billion

Growth = 6%

Rate of return = 4.95/360 + 6%

= 1.375 + 6%

= 7.375%