Question

​Covan, Inc. is expected to have the following free cash​ flow:

Year 1 2 3 4

FCF 10 12 13 14

Grow by 4 % per year

a. Covan has 6 million shares​ outstanding, ​$4 million in excess​ cash, and it has no debt. If its cost of capital is 11 %​, what should be its stock​ price?

b. Covan adds its FCF to​ cash, and has no plans to add debt. If you plan to sell Covan at the beginning of year​ 2, what is its expected​ price?

c. Assume you bought Covan stock at the beginning of year 1. What is your expected return from holding Covan stock until year​ 2?

Answer 1

a.
Stock price	Enterprise value + Cash - Debt/No of shares outstanding
Enterprise value is calculated as present value of future free cash flow
Year	FCF	Discount rate @11%	Present value
1	$10	$0.9009	$9.01
2	$12	$0.8116	$9.74
3	$13	$0.7312	$9.51
4	$14	$0.6587	$9.22
4	$208	$0.6587	$137.02
Terminal value	14*(1.04)/(0.11-0.04)
Terminal value	$208
Stock price	(137.02+4-0)/6
Stock price	$23.50
Thus, its stock price would be $23.50
b.
Stock price	Enterprise value + Cash - Debt/No of shares outstanding
Enterprise value is calculated as present value of future free cash flow
Year	FCF	Discount rate @11%	Present value
1	$12	$0.9009	$10.81
2	$13	$0.8116	$10.55
3	$14	$0.7312	$10.24
3	$208	$0.7312	$152.09
			$183.69
Terminal value	14*(1.04)/(0.11-0.04)
Terminal value	$208
Stock price	(183.69+4-0)/6
Stock price	$31.28
Thus, its stock price would be $31.28
c.
Expected rate of return	(31.28-23.50)/23.50
Expected rate of return	7.78/23.50
Expected rate of return	33.11%