Wenyu Li MINI CASE Essay

Custom Student Mr. Teacher ENG 1001-04 17 September 2016


Your employer, a mid-sized human resources management company, is considering expansion into related fields, including the acquisition of Temp Force Company, an employment agency that supplies word processor operators and computer programmers to businesses with temporary heavy workloads. Your employer is also considering the purchase of a Biggerstaff & Biggerstaff (B&B), a privately held company owned by two brothers, each with 5 million shares of stock. B&B currently has free cash flow of $24 million, which is expected to grow at a constant rate of 5%. B&B’s financial statements report marketable securities of $100 million, debt of $200 million, and preferred stock of $50 million. B&B’s WACC is 11%. Answer the following questions. a. Describe briefly the legal rights and privileges of common stockholders.

1. Right to share income and assets
2. Control of the firm
3.Preemptive right
4. Voting right. Common stockholders can attend at annual general meeting to cast vote or use a proxy b. (1) Write out a formula that can be used to value any stock, regardless of its dividend 
 (2) What is a constant growth stock? How are constant growth stocks valued?
 A constant growth stock is a stock whose dividends are expected to grow at a constant rate in the foreseeable future. This condition fits many established firms, which tend to grow over the long run at the same rate as the economy, fairly well. The value of a constant growth stock can be determined using the following equation:

(3) What happens if a company has a constant g that exceeds its rs? Will many stocks 
have expected g > rs in the short run (i.e., for the next few years)? In the long run 
(i.e., forever)? 
 If g > rs, the stock price is negative which does not make sense. The model simply cannot be used unless (1) rs > g, (2) g is expected to be constant, and (3) g can reasonably be expected to continue indefinitely. Stocks may have periods of supernormal growth, where gs > rs; however, this growth rate cannot be sustained indefinitely. In the long-run, g < rs. c. Assume that Temp Force has a beta coefficient of 1.2, that the risk-free rate (the yield 
on T-bonds) is 7.0%, and that the market risk premium is 5%. What is the required 
rate of return on the firm’s stock? 
 rs = = 7% + (12% – 7%)(1.2) = 7% + (5%)(1.2) = 7% + 6% = 13%. d. Assume that Temp Force is a constant growth company whose last dividend (D0, 
which was paid yesterday) was $2.00 and whose dividend is expected to grow indefinitely at a 6% rate.
 (1) What is the firm’s current estimated intrinsic stock price?

(2) What is the stock’s expected value 1 year from now? 
= D1/rs-g=2.2472/0.13-0.06=$32.1
(3) What are the expected dividend yield, the expected capital gains yield, and the expected total return during the first year? Dividend Yield
R =13%
Expected capital gains yield = r- Dn/pn-1=6%
e. Suppose Temp Force’s stock price is selling for $30.29. Is the stock price based more on long-term or short-term expectations? Answer this by finding the percentage of Temp Force’s current stock price that is based on dividends expected during Years 1, 2, and 3. 
 D1=2.6 D2=3.38 D3=4.394 D4=4.658

P0=46.66 / P3=54.109 = 86%

f. Why are stock prices volatile? Using Temp Force as an example, what is the impact on the estimated stock price if g falls to 5% or rises to 7%? If rs changes to 12%% or to 14%? 
 P0 = D1 / (rs – g)

g. Now assume that the stock is currently selling at $30.29. What is its expected rate of return? 
 RS=D1/P0+g = 2.12/30.29+0.06 = 13%h. Now assume that Temp Force’s dividend is expected to experience nonconstant growth of 30% fromYear 0 to Year 1,25% from Year 1 to Year2, and 15% fromYear2 toYear3. After Year 3, dividends will grow at a constant rate of 6%. What is the stock’s intrinsic value under these conditions? For many companies, it is unreasonable to assume that it grows at a constant growth rate.

Hence, valuation for these companies proves a little more complicated. The valuation process, in this case, requires us to estimate the short-run non-constant growth rate and predict future dividends. Then, we must estimate a constant long-term growth rate at which the firm is expected to grow. Generally, we assume that after a certain point of time, all firms begin to grow at a rather constant rate. Of course, the difficulty in this framework is estimating the short-term growth rate, how long the short-term growth will hold, and the long-term growth rate. What are the expected dividend yield and capital gains yield during the first year? P0=46.66 Expected dividend yield= 2.6/46.66 = 5.6%

Capital gains yield= 7.4%
What are the expected dividend yield and capital gains yield during the fourth year (from Year 3 to Year 4)? 
 P3= 56.5964
Expected dividend yield = 7.0%
Capital gains yield= 6.0%
i. What is free cash flow (FCF)?

A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it’s tough to develop new products, make acquisitions, pay dividends and reduce debt. FCF is calculated as:EBIT(1-Tax Rate) + Depreciation & Amortization – Change in Net Working Capital – Capital ExpenditureIt can also be calculated by taking operating cash flow and subtracting capital expenditures. This may be useful to parties such as equity holders, debt holders, preferred stock holders, convertible security holders, and so on when they want to see how much cash can be extracted from a company without causing issues to its day to day operations. What is the weighted average cost of capital?

A calculation of a firm’s cost of capital in which each category of capital is proportionately weighted. All capital sources – common stock, preferred stock, bonds and any other long-term debt – are included in a WACC calculation. All else equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk.

What is the free cash flow valuation model?

Free Cash Flow = Net Income + Depreciation + Deferred Taxes – Dividends Paid- Capital Expenditures j. Use a pie chart to illustrate the sources that comprise a hypothetical company’s total value. Using another pie chart, show the claims on a company’s value. How is equity a residual claim?

k. Use B&B’s data and the free cash flow valuation model to answer the following questions. 
(1) What is its estimated value of operations?
Operating Income = Revenue – Cost of Goods Sold (COGS), Labor, and day-to-day expenses= 24000000- (2) What is its estimated total corporate value?  Total corporate value = Value of operations + marketable securities= + 
(3) What is its estimated intrinsic value of equity? Intrinsic value of equity = Total net worth of company/ Total number of equity shares. 
(4) What is its estimated intrinsic stock price per share? 
 . Estimate the expected earnings per share of the stock.

b. Establish a price earning multiplier (or P/E ratio).
c. Develop a value anchor and a value range.
l. You have just learned that B&B has undertaken a major expansion that will change its expected free cash flows to −$10 million in 1 year, $20 million in 2 years, and $35 million in 3 years. After 3 years, free cash flow will grow at a rate of 5%. No new debt or preferred stock was added; the investment was financed by equity from the owners. Assume the WACC is unchanged at 11% and that there are still 10 million shares of stock outstanding. 
 (1) What is the company’s horizon value (i.e., its value of operations at Year 3)? 35000000/(1+ 5%)3 +

What is its current value of operations (i.e., at Time 0)? 
 Operating Income = Revenue – Cost of Goods Sold (COGS), Labor, and day-to-day expenses (2) What is its estimated intrinsic value of equity on a price-per-share basis? 
 VPS=Value of common equity/ # of shares outstanding

m. Compare and contrast the free cash flow valuation model and the dividend growth 
 Free Cash Flow Valuation Model:

In corporate finance, free cash flow (FCF) is a way of looking at a business’s cash flow to see what is available for distribution among all the securities holders of a corporate entity. This may be useful to parties such as equity holders, debt holders, preferred stock holders, convertible security holders, and so on when they want to see how much cash can be extracted from a company without causing issues to its day to day operations. The free cash flow can be calculated in a number of different ways depending on audience and what accounting information is available. A common definition is to take the earnings before interest and taxes add any depreciation & Amortization then subtract any changes in working capital and capital expenditure. A number of refinements and adjustments may also be made to try and eliminate distortions depending on the audience and their intentions.

The free cash may be different to the net income for a particular accounting period as the free cash flow takes into account the consumption of capital goods and the increases required in working capital. For example in a growing company with a 30 day collection period for receivables, a 30 day payment period for purchases, and a weekly payroll, it will require more and more working capital to finance its operations because of the time lag for receivables even though the total profits has increased. If the net income was extracted from the business it would cause cash flow problems for the business.

Dividend Growth Model:

The official description of the Dividend Growth Model is; ‘A stock valuation model that deals with dividends and their growth, discounted to today. This model assumes that the basis of the valuation of stock is:

•The Current Dividend
•Growth of the Dividend
•Required Rate of Return

Gordon Growth Model
D = Expected dividend per share one year from now
k = Required rate of return for equity investor
G = Growth rate in dividends (in perpetuity)
Because the model simplistically assumes a constant growth rate, it is generally only used for mature companies (or broad market indices) with low to moderate growth rates.

n. What is market multiple analysis?

A market multiples analysis is a financial modeling method of assigning a value to assets or to a business. Analysts often use the P/E multiple (the price per share divided by the earnings per share) or the P/CF multiple (price per share divided by cash flow per share, which is the earnings per share plus the dividends per share) to value stocks. For example, estimate the average P/E ratio of comparable firms. This is the P/E multiple. Multiply this average P/E ratio by the expected earnings of the company to estimate its stock price. The entity value (V) is the market value of equity (# shares of stock multiplied by the price per share) plus the value of debt. Pick a measure, such as EBITDA, sales, customers, eyeballs, etc. Calculate the average entity ratio for a sample of comparable firms. For example, V/EBITDA, V/customers.

Then find the entity value of the firm in question. For example, multiply the firm’s sales by the V/sales multiple, or multiply the firm’s # of customers by the V/customers ratio. The result is the total value of the firm. Subtract the firm’s debt to get the total value of equity. Divide by the number of shares to get the price per share. There are problems with market multiple analysis. (1) It is often hard to find comparable firms. (2) The average ratio for the sample of comparable firms often has a wide range. o. Suppose a share of preferred stock pays a dividend of $2.10 and 
investors require a return of 7%. What is the estimated value of the preferred stock? 

Free Wenyu Li MINI CASE Essay Sample


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  • University/College: University of Arkansas System

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  • Date: 17 September 2016

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