Question

Chewy Corporation is an all equity firm. Sales next year are expected to be $500 million and will grow at the rate of 10 percent over the following two years. Depreciation is expected to be 20 percent of sales and with other costs occupying 40 percent of sales. The tax rate is 40 percent.

A.) If next investment in net working capital and capital spending occupy 10 percent of sales, compute Chewy's free cash flow (FCF) for years 1 through 3.

B.) If after year 3, sales are assumed to grow at a rate of 6 percent into the foreseeable future, what is the estimated price of Chewy's stock today based on the future free cash flows (assume there are 12 million shares of stock outstanding)?

Answer 1

FCF = (Sales - Costs - Depreciation) x (1 - tax rate) + Depreciation - NWC - Capex

= Sales x [(1 - 40% - 20%) x (1 - 40%) + 20% - 10% - 10%]

= 24% x Sales

FCF in year 1 = 24% x 500 = $120 million

FCF in year 2 = 120 x (1 + 10%) = $132 million

FCF in year 3 = 132 x (1 + 10%) = $145.2 million

In order to calculate the stock price, we need to know the discount rate, which is not mentioned.

FCF in year 4 = 145.2 x (1 + 6%) = $153.91 million

Terminal Value in year 3, TV = FCF 4 / (r - g) = 153.91 / (16% - 6%) = $1,539.1 million

Equity Value = FCF1 / (1 + r) + FCF2 / (1 + r)^2 + (FCF3 + TV) / (1 + r)^3

= 120 / 1.16 + 132 / 1.16^2 + (145.2 + 1539.1) / 1.16^3

= $1,280.62

Stock Price = 1,280.62 / 12 = $106.72