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 $10.48 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.)

Answer 1

The stock of CoolTech Inc will IPO at a price of $ 10.48 per share. To value the stock we will use the free cash flow model.

The cash flow will grow @ 4% beyond 2023 and the cash flow of 2023 is $ 1,130,000.

Thus, the present value of cash flows beyond 2023 :-

Present Value of growing perpetuity = Cash Flow1 * - T -9

Cash flow1 = Cash flow at period 1

r = Required rate of return

g = Growth Rate

Present Value = (1,130,000 + (0.04 * 1,130,000)) * = 0.12 -0.04

Present Value = 1, 175, 200 * 0.08

Present Value = 14,690,000

Thus, the free cash flows of the firm and calculation of value of firm are as follows :-

Year Year 2020 2021 2022 2023 FCF 1 7,50,000.00 2 8,60,000.00 9,90,000.00 4 11,30,000.00 4 1,46,90,000.00 DF @ 12% 0.8929 0.7972 0.7118 0.6355 0.6355 3 Present Value 6,69,642.86 6,85,586.73 7,04,662.45 7,18,135.43 93,35,760.57 1,21,13,788.04 2023 Total

DF i.e, Discounting factor = 1/(1+r)n were, r = required rate and n = year/ period.

Value of firm = $ 1,21,13,788.04

Value of equity = Value of firm - Value of debt - Value of preferred stock

Value of equity = 1,21,13,788.04 - 24,20,000 - 9,70,000

Value of equity = $ 87,23,788.04

Value per share = Value of equity/ Number of shares

Value per share = 87,23,788.04 / 1,100,000

a. Value per share = $ 7.93.

b. The value of share as per free cash flow model is $ 7.93 and in IPO is $ 10.48. Thus, at this offering price one should not buy the stock in the IPO.

c. If the growth rate is 5% instead of 4%.

Present Value of growing perpetuity = Cash Flow1 * - T -9

Present Value = (1, 130,000 + (0.05 * 1,130,000)) * – 0.12 -0.05

Present Value = 11,86,500 * 1/0.07

Present Value = $ 1,69,50,000.

The free cash flows of the firm and calculation of value of firm are as follows :-

Year Year 2020 2021 2022 2023 FCF 7,50,000.00 2 8,60,000.00 9 ,90,000.00 4 11,30,000.00 4 1,69,50,000.00 DF @ 12% 0.8929 0.7972 0.7118 0.6355 0.6355 3 Present Value 6,69,642.86 6,85,586.73 7,04,662.45 7,18,135.43 1,07,72,031.43 1,35,50,058.89 2023 Total

Value of firm = $ 1,35,50,058.89

Value of equity = Value of firm - Value of debt - Value of preferred stock

Value of equity = 1,35,50,058.89 - 24,20,000 - 9,70,000

Value of equity = $ 1,01,60,058.89.

Value per share = Value of equity/ Number of shares

Value per share = 1,01,60,058.89 / 1,100,000.

Value per share = $ 9.24 per share.

The value of share as per free cash flow model is $ 9.24 and in IPO is $ 10.48. Thus, at this offering price one should not buy the stock in the IPO.