Question #72

Free cash flow to equity valuation uses the opportunity cost relevant to stockholders, which is the cost of equity. (Module 21.1, LOS 21.a) Beachwood Builders merged with Country Point Homes in December 31, 1992. Both companies were builders of mid- scale and luxury homes in their respective markets. In 2004, because of tax considerations and the need to segment the businesses between mid-scale and luxury homes, Beachwood decided to spin-off Country Point, its luxury home subsidiary, to its common shareholders. Beachwood retained Bernheim Securities to value the spin-off of Country Point as of December 31, 2004. When the books closed on 2004, Beachwood had $140 million in debt outstanding due in 2012 at a coupon rate of 8%, a spread of 2% above the current risk free rate. Beachwood also had 5 million common shares outstanding. It pays no dividends, has no preferred shareholders, and faces a tax rate of 30%. When valuing common stock, Bernheim's valuation models utilize a market risk premium of 11%. The common equity allocated to Country Point for the spin-off was $55.6 million as of December 31, 2004. There was no long-term debt allocated from Beachwood. The Managing Director in charge of Bernheim's construction group, Denzel Johnson, is prepping for the valuation presentation for Beachwood's board with Cara Nguyen, one of the firm's associates. Nguyen tells Johnson that Bernheim estimated Country Point's net income at $10 million in 2004, growing $5 million per year through 2008. Based on Nguyen's calculations, Country Point will be worth $223.7 million at the end of 2008. Nguyen decided to use a cost of equity for Country Point in the valuation equal to its return on equity at the end of 2004 (rounded to the nearest percentage point). Nguyen also gives Johnson the table she obtained from Beachwood projecting depreciation (the only non-cash charge) and capital expenditures: $(in millions) 2004 2005 2006 2007 2008 Depreciation 5 6 5 6 5 Capital Expenditures 7 8 9 10 12 Looking at the numbers, Johnson tells Nguyen, "Country Point's free cash flow (FCF) will be $25 million in 2006." Nguyen adds, "That's FCF to the Firm (FCFF). FCF to Equity (FCFE) will be lower."