Question

Using the information below, answer the questions:

• Firm named Galaxy has a free cash flow (FCF) of $13 million.

• Galaxy's net income is $50million and total book equity is $105million

• Galaxy's debt-to-equity ratio is 1.25

• Galaxy's market value of debt is 150 million

• Galaxy's tax rate is 25%

• Galaxy’s FCF and earnings will grow at a constant rate of 3%

• Galaxy’s equity beta is 1.3

• US 3 month T-bill rate is 1.5%

• S&P 500 market return is 7.5%

• Currently Galaxy Interiors do not pay dividends.

• There are 10 million shares outstanding.

#1) What should be the fair stock value per share using the Residual Income Model (RIM) ?

#2) What should be the fair stock value per share using the Free Cash Flow (FCF) Valuation model?

#1) stock price per share with RIM = approx. $24

#1) stock price per share with RIM = approx. $77

#1) stock price per share with RIM = approx. $15

#1) stock price per share with RIM = approx. $69

#2) stock price per share with FCF model = approx. $59

#2) stock price per share with FCF model = approx. $84

#2) stock price per share with FCF model = approx. $38

#2) stock price per share with FCF model = approx. $41

Answer 1

#1) Fair stock value per share using the Residual Income Model (RIM)

Formula is Current Book value of equity +PV of residual income

where,

Book value of equity is given as $ 105 mln.

Residual income=Net income-Equity charge

Equity charge=Equity capital*Cost of equity

With the given details,we can find the cost of equity as per CAPM

Cost of equity,ke =RFR+Beta*(Market return-RFR)

ie.1.5%+(1.3*(7.5%-1.5%))=

9.3%

So now,

Residual income=Net income-Equity charge

ie.50-(105*9.3%)=

40.235

PV of residual income=RI(1)/(ke-g)

ie.40.235*1.03/(9.3%-3%)=

657.8103175

millions

So,total value of equity=BV of Equity+PV of RI

ie.105+657.81=

762.81

millions

No.of shares o/s= 10 mln.

So, fair stock value/share=762.81/10=

76.281

ie.$ 77 approx.

So, the ANSWER is:

#1) stock price per share with RIM = approx. $77

#2)Fair stock value per share using the Free Cash Flow (FCF) Valuation model

We will find the total value of firm, discounting the constantly-growing FCFs by using WACC , then subtract debt--to find the value of equity--then finding per share value by dividing by no.of shares o/s, 10 mlns.