Question

0. An analyst estimates that the next year's free cash flow to equity (FCFE) of Coca Cola will be $10 and that FCFE will grow from next year at a constant rate of 4% (g). In addition, he estimates a required rate of return on equity (r) of 10%. If the analyst allows r and g to vary by 25 basis points (0.25%), which of the following combinations of r and g will give the highest value estimate for Coca Cola's shares?

   1. When r = 10.25% and g = 3.75%

   2. When r = 9.75% and g = 4.50%

   3. When r = 10% and g = 4%

   4. When r = 9.75% and g = 4.25%

Answer 1

the next year's free cash flow to equity (FCFE) of Coca Cola will be $10

Growth rate = 4%

Rate of return = 10%

According to Gordon growth model,

Intrinsic value of the Stock =( FCFE next year ) / ( rate of return - growth rate)

• When r = 10.25% and g = 3.75%

Value = 10/ (0.1025- 0.0375) = 153.85

• When r = 9.75% and g = 4.50%

Value = 10/ (0.0975- 0.0450) = 190.48

• When r = 10% and g = 4%

Value = 10/ (0.1- 0.04) = 166.67

• When r = 9.75% and g = 4.25%

Value = 10/ (0.0975- 0.0425) = 181.81

So, r = 9.75% and g = 4.50% will give the highest value estimate