Question

The free cash flows (in millions) shown below are forecast by Simmons Inc. Year: 1 2 3 Free cash flow: -$25 $50 $55 respectively. If the weighted average cost of capital is 12% and the free cash flows are expected to continue growing at the same rate after Year 3 as from Year 2 to Year 3, what is the Year 0 value of operations, in millions? The balance sheet shows $25 million of short-term investments that are unrelated to operations, $50 million of accounts payable, $90 million of short-term debt, $25 million of long-term debt, $40 million of preferred stock, and $100 million of common equity. Simmons Inc. has 10 million shares of stock outstanding. What is the best estimate of the stock’s price per share?

Answer 1

Part 1)

Step 1: Calculate Growth Rate

The growth rate is calculated as below:

Growth Rate = Free Cash Flow Year 3/Free Cash Flow Year 2 - 1 = 55/50 - 1 = 10%

_____

Step 2: Calculate Terminal Value at Year 2

The terminal value at year 2 is arrived as below:

Terminal Value = Free Cash Flow Year 3/(WACC - Growth Rate) = 55/(12% - 10%) = $2,750

_____

Step 3: Calculate Year 0 Value of Operations

The year 0 value of operations is determined as follows:

Year 0 Value of Operations = Free Cash Flow Year 1/(1+WACC)^1 + (Free Cash Flow Year 2 + Terminal Value)/(1+WACC)^2 = -25/(1+12%)^1 + (50 + 2,750)/(1+12%)^2 = $2,209.82 or $2,210 million

Answer for Part 1) is $2,209.82 or $2,210 million

_____

Part 2)

The best estimate of the stock’s price per share is arrived as below:

Best Estimate of the Stock’s Price Per Share = Market Value of Equity/Number of Shares Outstanding

Here, Value of Equity = Value of Operations (as calculated in Part 1) + Short Term Investments - Short-Term Debt - Long-Term Debt - Preferred Stock = 2,209.82 + 25 - 90 - 25 - 40 = 2079.82 million and Number of Shares Outstanding = 10 million

Substituting values in the above formula, we get,

Best Estimate of the Stock’s Price Per Share = 2079.82/10 = $207.98 or $208

Answer for Part 2) is $207.98 per share or $208 per share