Question

​Covan, Inc. is expected to have the following free cash​ flow:

Year	1	2	3	4	•••
FCF	11	13	14	15	Grow by 3% per year

a. Covan has 8 million shares​ outstanding, $4 million in excess​ cash, and it has no debt. If its cost of capital is 13%​, what should be its stock​ price?

b. Covan adds its FCF to​ cash, and has no plans to add debt. If you plan to sell Covan at the beginning of year​ 2, what is its expected​ price?

c. Assume you bought Covan stock at the beginning of year 1. What is your expected return from holding Covan stock until year​ 2?

Answer 1

Requirememt a

Value of the firm (V)

= (11/1.13)+(13/(1.13)^2)+(14/(1.13)^3)+(15/(1.13)^4)+ (((15 x1.03)/((0.13-0.03) x(1.13^4))

=$ 133.58

Share price = (V+cash -Debt)/Shares outstanding

= ($133.58 + $4 -0)/ 8 = $17.20

Requirememt b

Value of the firm (V) at beginning of year 2

=(13/(1.13))+(14/(1.13)^2)+(15/(1.13)^3)+ (((15 x1.03)/((0.13-0.03) x(1.13^3))

'= $ 134.94

Expected Share price = (V+cash -Debt)/Shares outstanding

= ($139.94 + $4 -0)/ 8 = $17.99

Requirememt c

Expected return = (17.99-17.20)/17.20

= 0.0462 or 4.62%

Note: Assumed free cash flow are in millions