Question

P7–17 Using the free cash flow valuation model to price an IPO Assume that you have an

opportunity to buy the stock of CoolTech, Inc., an IPO being offered for $12.50 per

share. Although you are very much interested in owning the company, you are concerned

about whether it is fairly priced. To determine the value of the shares, you

have decided to apply the free cash flow valuation model to the firm’s financial data

that you’ve developed from a variety of data sources. The key values you have compiled

are summarized in the following table.

Free cash flow

Year (t) FCFt Other data

2016 $ 700,000 Growth rate of FCF, beyond 2019 to infinity 5 2%

2017 800,000 Weighted average cost of capital 5 8%

2018 950,000 Market value of all debt 5 $2,700,000

2019 1,100,000 Market value of preferred stock 5 $1,000,000

Number of shares of common stock outstanding 5 1,100,000

a. Use the free cash flow valuation model to estimate CoolTech’s common stock

value per share.

b. Judging on the basis of your finding in part a and the stock’s offering price,

should you buy the stock?

c. On further analysis, you find that the growth rate in FCF beyond 2019 will be

3% rather than 2%. What effect would this finding have on your responses in

parts a and b?

Answer 1

a) to find out the value of the common stock per share, we will first calculate the value of the firm as a whole and then subtract the market value of all debts and preferred stock.

Given
r = 8%

g =2%

Value of the firm is the present value of all the future cash flows

Value = CF1 / ( 1 + r) + CF2 / ( 1 + r)^2 + CF3 / ( 1 + r)^3 + CF4 / ( 1 + r)^4 + TV / ( 1+ r)^4

where, terminal value is calculated as follows

TV = CF4 * ( 1 + g) / ( r - g)

TV = 1100000 * ( 1 + 0.02) / ( 0.08 - 0.02)

TV = 1122000 / 0.06

TV = $18700000

Putting in the above equation

Value = 700000 / 1.08 + 800000/1.08^2 + 950000/1.08^3 + 1100000/1.08^4 + 18700000/1.08^4

Value = $648148.148 + 685871.056 + 754140.629 + 808532.838 + 13745058.25

Value = $16641750.92

Value of common stock = value of the firm - value of debt - value of preferred stock

Value of common stock = 16641750.92 - 2700000 - 1000000

Value of common stock = $12941750.92

Value of stock per share = 12941750.92 / 1100000

Value of stock per share = $11.77

b) No, I would not buy the stock as the offering price is higher than what the intrinsic value of CoolTech's common stock is. Thus, the offered price seems to be overvalued.

c) If the terminal value has a growth of 3% instead of 2% then, new terminal value would be

TV = 1100000 * ( 1 + 0.03) / ( 0.08 - 0.03)

TV = $22660000

Putting it in the value formula

Value =

Value = 700000 / 1.08 + 800000/1.08^2 + 950000/1.08^3 + 1100000/1.08^4 + 22660000/1.08^4

Value = $648148.148 + 685871.056 + 754140.629 + 808532.838 + 16655776.5

Value = 19552469.1

Value of common stock = 19552469.1 - 2700000 - 1100000

Value of common stock = 15752469.1

Value of stock per share = 15752469.1 / 1100000

Value of stock per share = $14.32

Intrinsic value of the common stock is now higher than the offered price, hence I would buy the stock. This is because the stock has the potential to grow because of its under-priced offer value