Question

Financial analyst is evaluating XS Company by using the FCFF valuation approach. The analyst has collected the following information on its expected revenues and after-tax operating income (in $ millions), each year for the next 5 years:

Expected Growth rate Revenues EBIT (1-t) Last year 1 2 3 4 5 8.00% 8.00% 8.00% 8.00% 8.00% $ 1 000.00 $1 080.00 $1 166.40 $1 259.71 $1 360.49 $1 469.33 $120.00 $129.60 $139.97 $151.17 $163.26 $176.32

The company currently has 250 million shares trading at $10/share (book value of equity=$1 000 million). The company also had $800 million in debt outstanding (both book and market value) and $500 million in non-core financial investments and cash. The cost of capital for the firm is expected to be 10% for the next 5 years and drop to 8% thereafter.

Questions:

1. Assuming that the company is going to reinvest 40% of it’s after-tax operating income in next 5 years, estimate the free cash flow to the firm each year for the next five years
2. After five years the expected growth rate of revenues and after-tax operating income drop to 3% in perpetuity and the company reinvestment rate drops to 30%. Estimate the terminal value of the company at the end of year 5.
3. Estimate the value of the equity per share today.

Answer 1

Part (a)

Year	Linkage	1	2	3	4	5
EBIT x (1 - T)	A	129.60	139.97	151.17	163.26	176.32
Reinvestment ratio	B	40%	40%	40%	40%	40%
Free cash flows	C = A x (1 - B)	77.76	83.98	90.70	97.96	105.79

Part (b)

Free cash flows in year 6 = FCF₆ = [EBIT x (1 - T)]_{year 5} x (1 + g_t) x (1 - Reinvestment ratio) = 176.32 x (1 + 3%) x (1 - 30%) =  127.13

Discount rate in the long term beyond year 5, r_t = 8%

the terminal value of the company at the end of year 5 = FCF₆ / (r_t - g_t) = 127.13 / (8% - 3%) =  2,542.53

Part (c)

r = discount rate for the first five years = 10%

Year, n	Linkage	1	2	3	4	5	6
EBIT x (1 - T)	A	129.60	139.97	151.17	163.26	176.32	181.61
Reinvestment ratio	B	40%	40%	40%	40%	40%	30%
Free cash flows	C = A x (1 - B)	77.76	83.98	90.70	97.96	105.79	127.13
Long term growth rate							3%
Discount rate		10%	10%	10%	10%	10%	8%
Terminal value	D					2,542.53
PV factor	E = (1 + r)^(-n)	0.9091	0.8264	0.7513	0.6830	0.6209
PV of free cash flows	F = C x E	70.69	69.41	68.14	66.90	65.69
PV of terminal value	G = D x E					1,578.71
Value of the firm	H = Sum of all F + G	1,919.54
[-] Debt	I	800.00
[+} non-core financial investments and cash	J	500.00
Value of equity	K = H - I + J	1,619.54
Nos. of shares (mn)	L	250.00
Equity per share today	K / L	6.48