Question #96
Reading: Reading 21 Free Cash Flow Valuation
PDF File: Reading 21 Free Cash Flow Valuation.pdf
Page: 45
Status: Unattempted
Question
SOX, Inc., expects high growth in the next 4 years before slowing to a stable future growth of 3%. The firm is assumed to pay no dividends in the near future and has the following forecasted free cash flow to equity (FCFE) information on a per share basis in the high- growth period: Year 1 Year 2 Year 3 Year 4 FCFE $3.05 $4.10 $5.24 $6.71 High-growth period assumptions: SOX, Inc.'s, target debt ratio is 40% and a beta of 1.3. The long-term Treasury Bond Rate is 4.0%, and the expected equity risk premium is 6%. Stable-growth period assumptions: SOX, Inc.'s, target debt ratio is 40% and a beta of 1.0. The long-term Treasury Bond Rate is 4.0% and the expected equity risk premium is 6%. Capital expenditures are assumed to equal depreciation. In year 5, earnings are $8.10 per share while the change in working capital is $2.00 per share. Earnings and working capital are expected to grow by 3% a year in the future. What is the present value on a per share basis for SOX, Inc.?
Answer Choices:
A. $70.49
B. $77.15
C. $64.24
Explanation
The required rate of return in the high-growth period is (r) = 0.04 + 1.3(0.06) = 0.118.
The required rate of return in the stable-growth period is (r) = 0.04 + 1.0(0.06) = 0.10.
The Present Value (PV) of the FCFE in the high-growth period is (3.05 / 1.118) + (4.10 /
1.1182) + (5.24 / 1.1183) + (6.71 / 1.1184) = 14.06.
The Terminal Price = Expected FCFEn + 1 / (r − gn) with FCFEn + 1 = FCFE in year 5 =Earnings
per share − (Capital Expenditures − Depreciation)(1 − Debt Ratio) − (Change in working capital)(1 − Debt
Ratio) = 8.10 − 0(1 − 0.4) − 2.00(1 − 0.4) = 6.90.
The Terminal Price = 6.90 / (0.10 − 0.03) = 98.57.
The PV of the Terminal Price = (98.57 / 1.1184) = 63.09.
The value of a share today is the PV of the FCFE in the high-growth period plus the PV of
the Terminal Price = 14.06 + 63.09 = 77.15.