Question

You have an option to buy Jack Clothing Corporation stocks. Based on the released financial statements, they have $500 million of debt and 14 million shares of stock outstanding. You expect the Corporation to generate the following cash flows over the next five years: Year 1 2 3 4 5 FCF($millions) 75 84 96 111 120 Beginning with year six, you estimate that the Corporation's free cash flows will grow at 6% per year and that their weighted average cost of capital is 15%. Would you be willing to buy a share at the price $39? And why or why not? Please show the equations and work of how answer was obtained.

Answer 1

WACC(weighted average cost of capital) = (cost of debt (K_d) * debt) / debt + equity+

cost of equity(Ke) * equity/equity + debt

equity = 14million * 39 = $546million

debt = $500million

debt + equity = 1046million

15% = K_d * 500/1046 + K_e * 546/1046

since nothing was given assuming cost of debt to be borrowed at risk free rate and risk free rate is 8%

on solving above sum we get Ke = 21.42%

YEAR CASHFLOWS DISC.FACTOR (21.42%) DISCOUNTED CASHFLOW

1 75 0.823 61.725

2 84 0.678 56.952

3 96 0.5586 53.62

4 111 0.46 51.06

5 120 0.378 45.36

6^* 778 0.312 242.73

total 511.447million

511.447million / 14million = 36.53

note:-

FCFE₆   = ( FCFF₅ / Ke - g ) = (120 / 21.42 - 6 ) = $778.2million

based on above info share is over valued. hence should not be bought.