Question

A company just reported the following results for its most recent fiscal year (year 0): Total revenues: $500 million, Operating profit margin: 40%, Tax rate: 25%, Reinvestment rate: 60%. It has $300 million debt and $2 million cash. Number of shares outstanding is 20 million. You forecast that the company will earn the same FCFF next year (FCFF1), which will then decline at a stable 2% rate (i.e., a negative growth rate) in perpetuity thereafter. You estimate that the company's cost of capital is 14%. How much would you be willing to pay for each share? a. $1.8 b. $2.7 c. $3.9 d. $5.1 e. $6.5

Answer 1

Given about year 0 for a company,

Total revenues = $500 million

operating profit margin = 40%

So, operating profit = 500*0.4 = $200 million

tax rate = 25%

So, Net operating profit after tax(NOPAT) = operating profit*(1-t) = 200*(1-0.25) = $150 million

reinvestment rate RR = 60%

So, FCFF0 = NOPAT*(1-RR) = 150*(1-0.6) = $60 million

next year FCFF is same as year 0

So, FCFF1 = $60 million

growth rate g = -2%

cost of capital Kc = 14%

So, firm value today using constant growth model is

EV0 = FCFF1/(Kc-g) = 60/(0.14 - (-0.02)) = $375 million

We know that,

Firm value = MV of debt + MV of equity - cash

So, 375 = 300 + MV of equity -2

=> MV of equity = $77 million

MV of equity = number of shares outstanding*current share price

So, 77 = 20*P0

=> P0 = $3.85 or approx $3.9

So, option c is correct.