Question #104

The two-stage FCFF model is most suited for analyzing firms growing at a rate faster than the overall economy. The two-stage model assumes a high rate of growth for an initial period, followed by an immediate jump to a constant, stable growth rate. (Module 21.5, LOS 21.j) Jon Binkster, CFA, is researching a U.S. based company Busicomb Inc., who have just released their financial statements for the year ended December 20x5. These financial statements are included in Exhibits 1–3 below. Exhibit 1 Busicomb Inc. Annual Income Statement For the Year Ended December 31, 20x5 (in $ millions) Sales 721.9 Operating expenses (417.0) Operating profit 304.9 Gain on sale of fixed assets 9.6 Depreciation (170.8) Earnings before interest and tax 143.7 Interest expense (40.3) Pre-tax income 103.4 Income taxes (31.0) Net income 72.4 Exhibit 2 Busicomb Inc. Balance Sheet As of December 31 (in $ millions) 20x5 20x4 Current Asset Cash and equivalents 31.2 14.0 Accounts receivable 72.0 64.8 Inventories 501.7 453.7 Total current assets 604.9 532.5 Non-Current Assets Property, plant, and equipment 1138.7 982.7 Less: Accumulated depreciation (370.0) (216.0) Net property, plant, and equipment 768.7 766.7 Total assets 1373.6 1299.2 Current Liabilities Accounts payable 60.1 62.5 Notes payable 30.0 20.0 Total current liabilities 90.1 82.5 Non-Current Liabilities Long term debt 576.0 588.0 Total liabilities 666.1 670.5 Shareholders Equity Common equity 384.0 360.0 Retained earnings 323.5 268.7 Total equity 707.5 628.7 Total liabilities and equity 1373.6 1299.2 Exhibit 3 Busicomb Inc. Cash Flow Statement For the Year Ended December 31, 20x5 (in $ millions) Cash Flow from Operating Activities Net income 72.4 Depreciation 170.8 Gain on sale of fixed assets (9.6) Change in Working Capital (Increase) Decrease in accounts receivable (7.2) (Increase) Decrease in inventories (48.0) Increase (Decrease) in accounts payable (2.4) Net change in working capital (57.6) Net cash from operating activities 176.0 Cash Flow from Investing Activities Purchase of property, plant, and equipment (183.2) Proceeds on disposal of plant and equipment 20.0 Net cash from investing activities (163.2) 12.8 Cash Flow from Financing Activities Change in debt outstanding (2.0) Change in common stock 24.0 Payment of cash dividend (17.6) Net cash from financing activities 4.4 Net change in cash and cash equivalents 17.2 Cash at beginning of period 14.0 Cash at end of period 31.2 Busicomb Inc. announces a new strategic alliance that will require it to sell products on behalf of a very successful major European manufacturing and distribution operation. Binkster decides to value Busicomb using the dividend discount model (DDM) and the free cash flow-to-firm model (FCFF). Binkster undertakes a review of the financial performance of Busicomb Inc. using Exhibits 1 to 3 and forecasts related to the new sales contract, Binkster reaches the following conclusions: Earnings are expected to grow at 18%, next year before stabilizing to a long-term growth rate of 6% after six years (i.e., year 6). You can assume that the growth rate declines evenly each year between the high growth and the low growth period. The current payout ratio will be maintained, and the firm has a long-term target debt to capital ratio of 50%. Busicomb Inc. has an equity beta of 1.3. Government bond yield is 4.5% and the market equity risk premium is 6%. There are 12 million shares outstanding. The market value of the debt in the balance sheet of Busicomb Inc. is not materially different from the book value. The required rate of return of the debt holders is 7%. The effective tax rate of Busicomb is 30%.