Question

Using the free cash flow valuation model to price an IPO Personal Finance Problem Assume that you have an opportunity to buy the stock of CoolTech, Inc., an IPO being offered for $8.36 per share. Although you are very much interested in owning the company, you are concerned about whether it is fairly priced. To determine the value of the shares, you have decided to apply the free cash flow valuation model to the firm's financial data that you've accumulated from a variety of data sources. The key values you have compiled are summarized in the following table, a. Use the free cash flow valuation model to estimate CoolTech's common stock value per share. b. Judging by your finding in part a and the stock's offering price, should you buy the stock? c. On further analysis, you find that the growth rate in FCF beyond 2023 will be 5% rather than 4%. What effect would this finding have on your responses in parts a and b? a. The value of CoolTech's entire company is $ . (Round to the nearest dollar) i Data Table (Click on the icon located on the top-right corner of the data table below in order to copy its contents into a spreadsheet.) Free cash flow Year (t) FCF 2020 $690,000 2021 $840,000 2022 $990,000 2023 $1,090,000 Other data Growth rate of FCF, beyond 2023 to infinity = 4% Weighted average cost of capital = 12% Market value of all debt = $2,340,000 Market value of preferred stock = $940,000 Number of shares of common stock to be issued = 1,100,000 Print Done

Answer 1

Part (a)

Please see the table below. Please be guided by the second column titled “Linkage” to understand the mathematics. You can also understand the mathematics making use of [+] / [-] sign appearing in the first column. The last row highlighted in yellow is your answer. Figures in parenthesis, if any, mean negative values. All financials are in $. Adjacent cells in blue contain the formula in excel I have used to get the final output.

N OP 2020 2021 2022 690,000 840,000 990,000 2023 1,090,000 12% M 84 Year (t) Linkage 85 Cash flows 86 Terminal Growth rate 87 WACC r 88 Terminal Value TV 89 Net Cashflows C + TV 90 Enterprise Value 91 (-) Market value if debt в 92 (-) Market value of preferred stock C 93 Value of common stock D=A-B-C 94 Nos. of common shares 95 Value / share D/N 14,170,000 '=Q85*(1+N86)/(N87-N86) 15,260,000 690,000 840,000 990,000 11,688,383 ENPV(N87,N89:289) 2,340,000 940,000 8,408,383 1,100,000 7.64

Part (b)

IPO price = $ 8.36 / share > intrinsic value = $ 7.64 / share

Since IPO price is higher, the stock is currently overvalued and hence I will not buy this stock.

Part (c)

Terminal growth rate is now 5%.

N 2020 690,000 2021 840,000 2022 990,000 2023 1,090,000 5% 12% L 84 Year (t) Linkage 85 Cash flows 86 Terminal Growth rate 87 WACC 88 Terminal Value TV 89 Net Cashflows C + TV 90 Enterprise Value 91 [-] Market value if debt 92 (-) Market value of preferred stock C 93 Value of common stock D = A-B-C 94 Nos. of common shares 95 Value / share D/N 16,350,000 =285*(1+N86)/(N87-N86) 17,440,000 690,000 840,000 990,000 13,073,812 '=NPV(N87,N89:289) 2,340,000 940,000 9,793,812 1,100,000 8.90

IPO price = $ 8.36 / share < intrinsic value = $ 8.90 / share

Since IPO price is lower, the stock is currently undervalued and hence I will buy this stock.