In: Finance

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?

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

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...

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 $12.30 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
accumulated from a variety...

Using the free cash flow valuation model to price an IPO
Personal Finance Problem Assume that it is the end of the year 2015
and you have an opportunity to buy the stock of CoolTech, Inc., an
IPO being offered for $2.13 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...

Using the free cash flow valuation model to price an
IPO Personal Finance Problem Assume that it is the end of year
2015 and you have an opportunity to buy the stock of CoolTech,
Inc., an IPO being offered for
$4.33
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...

Using the free cash flow valuation model to price an
IPO Personal Finance Problem Assume that it is the end of year
2015 and you have an opportunity to buy the stock of CoolTech,
Inc., an IPO being offered for
$4.33
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...

Using the free cash flow valuation model to price an
IPO Personal Finance Problem Assume that you have an opportunity
to buy the stock of CoolTech, Inc., an IPO being offered for
$5.12 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 accumulated...

12. 3: Basic Stock Valuation: Free Cash Flow Valuation Model
Basic Stock Valuation: Free Cash Flow Valuation Model The
recognition that dividends are dependent on earnings, so a reliable
dividend forecast is based on an underlying forecast of the firm's
future sales, costs and capital requirements, has led to an
alternative stock valuation approach, known as the free cash flow
valuation model. The market value of a firm is equal to the present
value of its expected future free cash...

Explain how to use the free cash flow valuation model to find
the price per share of common equity.

You have been assigned the task of using the corporate, or free
cash flow model to estimate KCB Corporation's intrinsic value. The
firm's WACC is 10.00%, its end-of-year free cash flow (FCF1) is
expected to be $75.0 million, the FCFs are expected to grow at a
constant rate of 5.00% a year in the future, the company has $200
million of long-term debt and preferred stock, and it has 30
million shares of common stock outstanding.
Why should the WACC...

Basic Stock Valuation: Free Cash Flow Valuation
Model
The recognition that dividends are dependent on earnings, so a
reliable dividend forecast is based on an underlying forecast of
the firm's future sales, costs and capital requirements, has led to
an alternative stock valuation approach, known as the free cash
flow valuation model. The market value of a firm is equal to the
present value of its expected future free cash flows:
Free cash flows are generally forecasted for 5 to...

ADVERTISEMENT

ADVERTISEMENT

Latest Questions

- What is the hidden-terminal problem as it relates to CSMA in wireless sensor networks?
- We wish to install a residential solar array at location Lat 400 N; Long 900W with...
- Should Parents Pay Their Children When They Earn High Grades in School? We all probably recall...
- Division A Division B Division C Sales revenue Income $1,800,000 $8,320,000 Average investment Sales margin 24...
- Describe the benefits of the private-equity ownership model versus public ownership and family-ownership.
- 1. Real heat engines, like the gasoline engine in a car, always have some friction between...
- Please cite your use of a source Which do you think arose first, in evolution: the...

ADVERTISEMENT