Question

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 $7.69 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 of data sources. The key values you have compiled are summarized in the following​ table (find table below)

a. Use the free cash flow valuation model to estimate​ CoolTech's common stock value per share.

b.  Judging by 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 2023 will be 3​% rather than 2​%. What effect would this finding have on your responses in parts a and b​?

Free Cash Flow

Year (t). FCF

2020. $720,000

2021. $840,000

2022. $970,000

2023. $1,060,000

Other Data

Growth rate of FCF, beyond 2023 to infinity = 2%

Weighted average cost of capital = 9%

Market value of all debt = $2,760,000

Market value of preferred stock = $1,100,000

Number of shares of common stock to be issued = 1,100,000

Answer 1

a]

total firm value = present value of FCF

present value of FCF = present value of FCF until 2023 + present value of terminal value at 2023

terminal value = 2024 FCF / (WACC - constant growth rate)

2024 FCF = 2023 FCF * (1 + 2%)

present value = future value / (1 + WACC)^{number of years}

Present value, or total firm value = $13,809,644

total equity value = total firm value - market value of debt - market value of preferred stock

total equity value = $13,809,644 - $2,760,000 - $1,100,000 = $9,949,644

value per share = total equity value / number of shares issued = $9,949,644 / 1,100,000 = $9.05

b]

Yes, you should buy the stock as the value per share is higher than the offer price per share

c]

If the growth rate is 3%, present value, or total firm value = $15,758,488

total equity value = $15,758,488 - $2,760,000 - $1,100,000 = $11,898,488

value per share = total equity value / number of shares issued = $11,898,488 / 1,100,000 = $10.82

There would be no change in the answer to B, as the value per share is still higher than the issue price per share.