Question

Problem 3 (9p) Abby Morgan is preparing a valuation of Generic Genetic Corporation. Abby has decided to use a three- stage free cash flow valuation model and the following estimates. The FCFE for year 2019 is $1,500,000. The FCFE is expected to grow at 10 percent in 2020, then at 16 percent annually for the following three years, and then at 6 percent in year 5 and thereafter. Generic Genetic's estimated beta is 2.00, and Abby believes that current market conditions dictate a 2.5 percent risk-free rate of return and a 6.0 percent market risk premium. Generic Genetic has 2 million outstanding common shares. Generic Genetic's before-tax cost of debt is 4.5%. The company has a capital structure consisting of 45 percent of debt and 55 percent of equity. The tax rate is 35%. Given Abby's assumptions and approach, estimate the value of a share of Generic Genetic.

Answer 1

value of share = Equity value / shares outstanding

Equity value = sum of present values of next 4 years FCF + present value of terminal value at end of year 4.

Terminal value at end of year 4 = Year 4 FCFE * (1 + g) / (k - g), where g = constant growth rate after year 4, and k = cost of equity.

The discount rate used to calculate present value is the cost of equity (k).

k = risk free rate + (beta * market risk premium) = 2.5% + (2 * 6%) = 14.5%.

Present value = future value / (1 + discount rate)^{number of years}

Value per share = $12.28

A PV of Terminal Value 1 Year FCFE 2 1 $ 1,650,000 3 2 $ 1,914,000 4 3 $ 2,220,240 4 $ 2,575,478 Terminal Value PV of FCFE $ 1,441,048 $ 1,459,926 $ 1,479,052 $ 32,117,731 $ 1,498,428 Equity Value $ 24,564,737 Shares o/s 2,000,000 Value per share $ 12.28 $ 18,686,282

ДА E Terminal Value PV of Terminal Value 1 Year 2 1 32 FCFE =1500000*(1+10%) =B2*(1+16%) =B3*(1+16%) =B4*(1+16%) 43 PV of FCFE =B2/(1+14.5%)^A2 =B3/(1+14.5%)^A3 =B4/(1+14.5%)^A4 =B5/(1+14.5%)^A5 =SUM(D2:05)+E5 2000000 =D6/07 =C5/(1+14.5%)^A5 =B5*(1+6%)/(14.5%-6%) Equity Value Shares o/s Value per share