Question

Answer questions (49) and (50) based on the information presented below. Camberly-Klark, a household product manufacturer, has 300 million common shares outstanding, trading at $50 per share. It recently reported yearly earnings per share of $4.00. The firm reported depreciation of $360 million in and capital expenditures of $625 million. The ratio of capital expenditures to depreciation is expected to remain constant and working capital needs are negligible. Camberly-Klark had debt outstanding of $10.0 billion, and intends to maintain its current financing mix of debt and common equity to finance future investment needs. The firm is expected to grow at 4% a year in perpetuity. The stock has a beta of 1.20, the equity risk premium is 6%, and the risk-free rate is 3%

49. Calculate intrinsic value per share for Camberly-Klark using the free cash flow to equity (FCFE) model. a. $55.97 b. $58.21 c. $59.95 d. $61.03

50. Assume that in an effort to block a takeover attempt that Camberly-Klark sells assets and uses the proceeds from that sale and excess cash to buy back 100 million common shares at the price of $50 per share. Calculate intrinsic value per share for Camberly-Klark using the free cash flow to equity (FCFE) model. Assume that Camberly-Klark will maintain the financing mix it secures following the share buyback. a. $86.09 b. $87.31 c. $89.53 d. $90.97

Answer 1

FCFE refers to Free Cash Flow To Equity which calculates the value of equity directly and value of a firm indirectly. This figure tells us how much of free cash flow is available to equity providers of the firm. It is calculated after taking into account capital expenditure and working capital requirements of the firm. It is a good measure of determing actual cash flows available for equity shareholders as it takess into acount all necessary expenses as well. It also includes net borrowings as this amount is available to equity capital providers after payment of interest, preference dividend, working capital and capex of the firm.

Q49.

FCFE = NI - (Capex - Depreciation) - Change in working capital + Net borrowings

Here,

NI = Net income

Capex = Capital expenditure

Net borrowings = Total debt borrowed - Debt repayments

If the values for net borrowings are not available we can use the following formula as well -

FCFE = NI - (Capex - Depreciation) (1 - D / R) - (Change in working capital) (1 - D / R)

Here,

D/R ratio is basically debt ratio. Debt ratio is = Total debt / Total assets

D/R ratio is used when the firm wants to keep the financing mix same, or the firm will maintain the proportion of debt in total capital of the firm. In this case D/R ratio will be calculated by dividing total debt by total liabilities value.

Given that debt outstanding = $10 billion or $10,000 million and,

Equity value = Price of shares * No. of shares

= $50 * 300 million

= $15,000 million

We are not provided with net working capital figures as they are negligible, so we will take total liabilities as -

Total laibilties = Total debt + Total equity

= $10,000 million + $15,000 million

= $25,000 million

Debt ratio = Total debt / Total assets (liabilities)  

(Total assets and total liabilities are same in a balance sheet)

D/ R ratio = $10,000 / $25,000

= 2 / 5

Also, net income = No. of shares * Earnings per share

Earnings per share (EPS) is $4 (given)

So, net income = 300 million * $4

= $1,200 million

And capital expenditure = $625 million , depreciation = $360 million

Now FCFE = NI - (Capex - Depreciation) (1 - D / R) - (Change in working capital) (1 - D / R)

= 1,200 - (625 - 360) (1 - 2 / 5) - (0) (1 - 2 / 5)

= 1,200 - 265 (3 / 5) - 0

= 1,200 - 159

= $1,041 million

Perpetuity growth is 4% according to question,and value of firm is calculated as -

Value of firm per FCFE = FCFE 1 / (Ke - g)

Here, FCFE 1 = FCFE for next year

Ke = Cost of equity

g = Growth rate of firm for perpetuity

This is a stable growth firm and we are given

Risk -free rate = 3% (Rf)

Equity risk premium = 6% (Rm - Rf)

Beta = 1.2

According to Capital Assets Pricing Model (CAPM), we measure the non- diversifiable risk of the firm to calculate cost of equity. So formula for Ke as per CAPM is -

Ke = Rf + Beta (Rm - Rf)

= 3% + 1.2 (6%)

= 3% + 7.2%

= 10.2%

Value of firm per FCFE = FCFE1 / (Ke - g)

= FCFE (1+g) / (10.2% - 4%)

= 1,041 (1 + 4%) / (6.2%)

= 1,082.64 / 6.2%

= $17,461.935 million

Intrinsic value per share = Value of firm / No. of shares

= 17,461.935 / 300

= 58.20645

= $58.21 per share

So the answer is option (b) i.e., $58.21.

Q50. The company buys back 100 million shares at $50 per share so new equity value is -

Equity = No. of shares remaining * $50

= (300 - 100) * $50

= 200 * 50

= $10,000 million

New FCFE = NI - (Capex - Depreciation) (1 - D / R) - (Change in working capital) (1 - D / R)

Net income = EPS * No. of shares

Total earnings were $1,200 million (300 million * $4)

Now, EPS = Earnings / No. of shares

= $1,200 / 200

= $6 per share

Net income = 200 * $6

= $1,200 million

Also D / R ratio is same which is 2/5 as firm intends to keep it's financing mix the same after buyback. So our D / R ratio is still going to be 2 / 5.

So, FCFE = NI - (Capex - Depreciation) (1 - D / R) - (Change in working capital) (1 - D / R)

= 1,200 - (625 -360) (1 - 2 / 5) - (0) (1 - 2 / 5)

= 1,200 - 265 (3 / 5) - 0

= 1,200 - 159

= $1,041 million

Value of firm per FCFE = FCFE1 / (Ke - g)

= 1,041 (1 + g) / (10.2% - 4%)

= 1,041 (1 + 4%) / 6.2%

= 1082.64 / 6.2%

=$17,461.935 million

Intrinsic value per share = Value of firm / No. of shares outstanding

As 100 million shares were brought back, outstanding no. of shares is 200 million

So, Intrinsic value per share = 17,461.935 / 200

= $87.31 per share

So the answer is option (b) i.e., $87.31.