Lincoln Systems Co, is an all equity firm with 15 million shares of outstanding. A discount rate of 17 percent is appropriate a firm of risk. It is required to value stocks by using Free Cash Flows. The company’s revenues are forecasted to 500 million in one year are expected grow at 10 percent per year for the two years after that 7 percent per year for the next two years, and 6 percent per year after that. Expenses including depreciation are 65 percent of revenues. Net investment, including net working capital and capital spending less depreciation, is 10 percent of revenues. Because all costs are proportional to revenues, net cash flows (referred to as free cash flows) grow at the same rate as do revenues.
a. Construct a worksheet for showing net cash flow for the first five years:
b. Calculate the price per share by using cash flows
c. Calculate the price per share by using the PE multiples. Assume that the price-earnings ratio for comparable firms in Lincoln system’s industry is 7.
Answer:
| Particulars | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | ||
| Revenues | 500,000,000.00 | 550,000,000.00 | 605,000,000.00 | 647,350,000.00 | 692,664,500.00 | ||
| Expenses including depreciation | 325,000,000.00 | 357,500,000.00 | 393,250,000.00 | 420,777,500.00 | 450,231,925.00 | ||
| Net Income | 175,000,000.00 | 192,500,000.00 | 211,750,000.00 | 226,572,500.00 | 242,432,575.00 | ||
| Net Investment including net working capital and capital spending less depreciation | 50,000,000.00 | 55,000,000.00 | 60,500,000.00 | 64,735,000.00 | 69,266,450.00 | ||
| a) | Free Cash flows | 125,000,000.00 | 137,500,000.00 | 151,250,000.00 | 161,837,500.00 | 173,166,125.00 | |
| No.of Shares | 15,000,000.00 | 15,000,000.00 | 15,000,000.00 | 15,000,000.00 | 15,000,000.00 | ||
| b) | Price pe share by using cash flow | 8.33 | 9.17 | 10.08 | 10.79 | 11.54 | |
| Cost of Capital @17% | 0.855 | 0.731 | 0.624 | 0.534 | 0.456 | ||
| Discounted Cash flow | 106,837,606.84 | 100,445,613.27 | 94,436,046.66 | 86,364,589.68 | 78,983,000.82 | ||
| c) | PE ration * EPS = Market Price Pershare | PE Ratio = 7 | 58.33 | 64.17 | 70.58 | 75.52 | 80.81 |
| Net Income | 175,000,000.00 | 192,500,000.00 | 211,750,000.00 | 226,572,500.00 | 242,432,575.00 | ||
| No.of Shares | 15,000,000.00 | 15,000,000.00 | 15,000,000.00 | 15,000,000.00 | 15,000,000.00 | ||
| EPS= | 11.67 | 12.83 | 14.12 | 15.10 | 16.16 | ||
| Market Price Per share= 7 * EPS | 81.67 | 89.83 | 98.82 | 105.73 | 113.14 |
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