Question

At the end of the year 2010 the CL Corporation had operating free cash flow (OFCF) of $300,000 and shares outstanding of 100,000. Total debt is currently $10,000,000. The company projects the following annual growth rates in OFCF

Year	Growth Rate
2011	25%
2012	20%
2013	15%
2014	10%
2015	12%
2016	14%
2017	16%
2018	18%

From year 2019 onward growth in OFCF is expected to remain constant at 5% per year. The stock has a beta of 1.1 and the current market price is $80. Currently the yield on 10-year Treasury notes is 5% and the equity risk premium is 4%. The firm can raise debt at a pre-tax cost of 9%. The tax rate is 25%. The proportion of equity is 55% and the proportion of debt is 45%.

A)Calculate the required rate of return on equity.

B)Calculate the weighted average cost of capital (WACC).

C)Calculate the present value now (Year 2010) of OFCF during the period of declining growth (that is for years 2011 to 2014).

D) Calculate the present value now (Year 2010) of OFCF during the period of declining growth (that is for years 2015 to 2018).

E) Calculate the present value now (Year 2010) of OFCF during the period of constant growth (that is for years 2019 onwards).

F) Calculate the total intrinsic value of the firm.

G) Calculate the intrinsic value of the stock now (Year 2010).

Answer 1

A) REQUIRED RATE OF RETURN ON EQUITY

Calulated using CAPM model

Rate of return on equity= Risk free rate+beta*risk premium

=(0.05+1.1*0.04)*100

=9.4%

B) WEIGHTED AVERAGE COST OF CAPITAL

particulars rate of return (a) (b) weight product( a*b)

Equity 9.4% 0.55 5.17

Debt(after tax) 6.75% 0.45 3.04

(0.09-25%of 0.09)*100

TOTAL(WACC) 8.21

ANSWER FOR PART (C)

year cash flow PVF@ 8.21% DCF

2011 300000+25%=375000 0.924 346500

2012 375000+20%=450000 0.854 384300

2013 450000+15%=517500 0.789 408308

2014 517500+10%=569250 0.729 414983

Present value of cash flows during declining period 1554091

D)present value of declining growth

year cash flow [email protected]% DCF

2015 569250+12%=637560 0.674 429715

2016 637560+14%=726818 0.623 452808

2017 726818+16%=843109 0.576 485631

2018 843109+18%=994869 0.532 529270

TOTAL 1897424