Question

1. The Johnson Investment Fund (JIF), a private equity group, is evaluating an investment in ABC, Inc (the “Company”). They plan to take the Company private, improve the Company’s operating efficiencies, and then bring it back public in two (2) years. The following information has been provided by JIF analysts who plan on calculating the Company's equity value using a Free Cash Flow to Equity Model. Assume the valuation date is January 1, 2021.

ABC Inc. (values in millions of USD, except percent and per share)
Investment horizon (years)	2		Marginal tax rate	21%
2021 Sales	300		cash	2,000
2022 Sales	330		Market value of debt	400
Expected net income margin	25%		Market value of equity	800
Terminal trailing PE multiple	15.0x		Historical debt ratio (dr)	33.33%
Depreciation and Amortization (% of sales)	5%		cost of debt	4.5%
Capex as a percent of sales	5%		cost of equity	25.0%
NWC as a percent of sales	2%		Shares outstanding	8

Using the FCFE model, estimate the equity value per share of ABC, Inc. common stock. Is the stock under- or over-valued in the market?

Answer 1

FCFE = net income - weight of equity ( Fixed Capital investment - Depreciation - working capital investment)

Net income

25 % of 300 for year 1 = 75

25% of 330 for year 2 = 82.5

Fixed Capital investment year 1 = 5% of 300 =15

Fixed Capital investment year 2 = 5% of 330 = 16.5

Working capital investment year 1 = 2% of 300 = 6

Working capital investment year 2 = 2% of 330 = 6.6

Depreciation year 1 = 5% of 300 = 15

Depreciation year 2 = 5% of 330 = 16.5

Weight of equity = market value of equity/( market value of equity + market value of debt)

=8/12

=0.667

Putting value in formula we get

FCFE YEAR 1 =75 - 0.667 * ( 15 -15 + 6) = 71

FCFE YEAR 2 = 82.5 - 0.667 * ( 16.5 - 16.5 + 6.6) =78.1

Value of equity = ( FCFE year 1 / 1+ cost of equity) + ( FCFE year 2 / (1+ cost of equity)²)

=106.78 million

Equity value per share = 106.78/8 = 13.35