Question

18.5

Amarindo, Inc. (AMR), is a newly public firm with 9.0 million shares outstanding. You are doing a valuation analysis of AMR. You estimate its free cash flow in the coming year to be $14.75 million, and you expect the firm's free cash flows to grow by 4.3 % per year in subsequent years. Because the firm has only been listed on the stock exchange for a short time, you do not have an accurate assessment of AMR's equity beta. However, you do have beta data for UAL, another firm in the same industry:

   Equity Beta   Debt Beta   Debt-Equity Ratio
UAL   1.65   0.33   1.1

AMR has a much lower debt-equity ratio of 0.33 , which is expected to remain stable, and its debt is risk free. AMR's corporate tax rate is 32 %, the risk-free rate is 4.9 %, and the expected return on the market portfolio is 11.4%.

a. Estimate AMR's equity cost of capital.

b. Estimate AMR's share price.

Answer 1

a). UAL Asset beta = [(1/2.1) x 1.65] + [(1.1/2.1) x 0.33] = 0.79 + 0.17 = 0.96

We can use this for AMR’s asset beta.To derive the equity beta, since AMR’s debt is risk free we have:

Equity Beta = Asset Beta x (1 + D/E) = 0.96 x 1.33 = 1.2749

From the SML,

re = 4.9% + 1.2749(11.4% - 4.9%) = 4.9% + 1.2749(6.5%) = 4.9% + 8.29% = 13.19%

b). WACC = [wD x kD x (1 - t)] + [wE x kE]

= [(0.33/1.33) x 4.9% x (1 - 0.32)] + [(1/1.33) x 13.19%] = 0.83% + 9.91% = 10.74%

Levered value of AMR (as a constant growth perpetuity):

VL= FCF/(r_wacc - g) = $14.75 / (10.74% - 4.3%) = $228.98 million

E = [E / (D + E)] x VL = $228.98 million x (1 / 1.33) = $172.16 million

Share price = Equity Value / No. of Outstanding Shares

= $172.16 million / 9 million = $19.13 per share