Question

1. Summit Energy is an alternative energy producer. Your hedge fund is interested in investing into the company. As an analyst, you need to estimate firm value and its price per share using the NPV method and report it to the energy portfolio manager. So far you’ve successfully forecasted its earnings for 2020-2022 (numbers are in millions).

	Actual earnings		Forecasted earnings
	2018	2019	2020	2021	2022
Revenues	25,650	24,368	25,220	26,481	26,746
Cost of goods sold	17,894	19,750	21,230	20,381	19,973
Gross Profit	7,756	4,618	3,990	6,101	6,773
SG&A	2,110	2,050	2,200	2,200	2,200
Depreciation	2,000	2,000	2,000	2,000	2,000
EBIT	3,646	568	-210	1,901	2,573
Tax expense (25%)	912	142	-52	475	643
Net income	2,735	426	-157	1,425	1,930

1. Calculate Summit’s free cash flows for 2022. Assume that annual net working capital represents 10% of revenues. In 2021 Summit plans to purchase new equipment for its new generation of windmills for $200 million. No other purchases are planned in 2020 or 2022

	Actual earnings		Forecasted earnings
	2018	2019	2020	2021	2022
Net income	2,735	426
Depreciation	2,000	2,000
Capital expenditures	0	0
Change in NWC	32	-128
Free cash flows	4,703	2,554

B. Summit Energy’s beta is 2.7. Calculate its expected rate of return if the market portfolio return is 12% and the risk free rate is 4%

C. Calculate Summit’s terminal value if free cash flows are expected to grow 2% perpetually starting 2023. Use its expected rate of return from question B as a discount rate

Answer 1

1. A. free cash flows for 2022 = Net Income + Depreciation - increase in net working capital - capital expenditures

free cash flows for 2022 = 1,930 + 2,000 - (26,746*10%) - 0 = 1,930 + 2,000 - 2,674.6‬0 - 0 = 1,255.4‬0

B. expected rate of return = risk-free rate + stock's beta*(market portfolio return - risk-free rate)

expected rate of return = 4% + 2.7*(12% - 4%) = 4% + 2.7*8% = 4% + 21.6‬% = 25.6‬%

C. terminal value = free cash flows for 2022*(1+perpetual growth rate)/(expected rate of return - perpetual growth rate)

terminal value = 1,255.4‬0*(1+0.02)/(0.256 - 0.02) = (1,255.40*1.02)/0.236‬ = 1,280.508‬/0.236 = 5,425.88