Question

Your employer, a mid-sized human resources management company, is considering expansion into related fields, including the acquisition of Temp Force Company, an employment agency that supplies word processor operators and computer programmers to businesses with temporary heavy workloads. Your employer is also considering the purchase of Biggerstaff & McDonald (B&M), a privately held company owned by two friends, each with 5 million shares of stock. B&M currently has free cash flow of $24 million, which is expected to grow at a constant rate of 5%. B&M’s financial statements report short-term investments of $100 million, debt of $200 million, and preferred stock of $50 million. B&M’s weighted average cost of capital (WACC) is 11%.

Answer the following questions.

a. Describe briefly the legal rights and privileges of common stockholders.

b. What is free cash flow (FCF)? What is the weighted average cost of capital? What is the free cash flow valuation model?

c. Use a pie chart to illustrate the sources that comprise a hypothetical company’s total value. Using another pie chart, show the claims on a company’s value. How is equity a residual claim?

d. Suppose the free cash flow at Time 1 is expected to grow at a constant rate of gL forever. If gL WACC, what is a formula for the present value of expected free cash flows when discounted at the WACC? If the most recent free cash flow is expected to grow at a constant rate of gL forever (and gL WACC), what is a formula for the present value of expected free cash flows when discounted at the WACC?

Answer 1

(a) Legal rights and privileges of common stockholders:

1. Right to Dividend: Dividend is the distribution of residual profits to shareholders of a company. Equity shareholders have a right to receive dividend (final as well as interim) if a Company declares it.

2. Voting rights: Shareholders have a right to vote at the Annual General Meeting with regard to certain matters as stated in Company Law.

3. Transfer of shares: Shareholders have the right to transfer (sell) their shares.

4. Transfer of ownership: When a shareholder buys a share of any company, it makes them the owner of that part of the company, which they can sell as per the profitability in the financial market.

(b) Free Cash Flow refers to the cash available to a Company for distribution to creditors and investors after taking care of all the operational expenses. Investors include preference shareholders as well as equity shareholders. FCF removes non-cash items from the income statement (like depreciation).

Weighted Average Cost of Capital takes into account all sources of finance that a Company uses for raising capital ,viz; equity, preference share capital, debentures etc and arrives at a overall cost of capital by calculating weighted average. Weights can be- Market value of the sources, Target Capital Structure Ratio, Book value of the sources.

Free Cash Flow Valuation Model: As per this valuation method, the value of a company is equal to the Present Value of its free cash flows earned in all the years discounted at the minimum required rate of return (Kc or Ke).

Two approaches are there:

1) Free cash flow to the Firm: Under this, the total value( sum of its equity and debt) of a Firm is equal to the PV of free cash flows to the firm discounted at WACC (Kc).

2) Free cash flow to Equity: The company's equity value is ascertained by calculating the PV of free cash flows to equity and using Ke as the discounting factor.

(c)

  

Equity is a residual claim because the profits that are remaining after distributions to creditors, debt holders, Government (tax), preference shareholders, are then distributed to equity shareholders as equity dividend. Equity shareholders have the last right/claim over a company's profits. A company may even choose to not distribute any dividend to equity holders in a given year due to losses/insufficient profits.

(d) PV of expected free cash flows growing at gL forever (from T1 onwards):

Value at T=1:  ((cash flow in year 1 *(1+gL))/ WACC- gL

hence, Present value at T=0: Value at T=1*discounting factor of 1st year

PV of most recent free cash flow: ((most recent cash flow*(1+gL))/ WACC- gL