Logout Open In App
Open In App
Warning: foreach() argument must be of type array|object, bool given in /var/www/html/web/app/themes/studypress-core-theme/template-parts/header/mobile-offcanvas.php on line 20

Chapter 4: Q13-9CP (page 443)

To continue with Sundanci, Abbey Naylor, CFA, has been directed to determine the value of Sundanci’s stock using the free cash flow to equity (FCFE) model. Naylor believes that Sundanci’s FCFE will grow at 27% for two years and 13% thereafter. Capital expenditures, depreciation, and working capital are all expected to increase proportionately with FCFE.

a. Calculate the amount of FCFE per share for the year 2013, using the data from Table 13.11.

b. Calculate the current value of a share of Sundanci stock based on the two-stage FCFE model.

c. i. Describe one limitation of the two-stage DDM model that is addressed by using the two-stage FCFE model.

ii. Describe one limitation of the two-stage DDM model that is not addressed by using the two-stage FCFE model.

Short Answer

Expert verified

Answer

a.$0.286

b.$40.7859

c. (i) Addressed – toestimate the value of a stock that pays no dividends

(ii) Un-addressed – growth assumptions limitaions.

Step by step solution

01

Calculation of FCFE for 2013

Sundanci's FCFE for the year 2013 = Earnings after tax + Depreciation expense - Capital expenditures - Increase in NWC

= $80 million + $23 million - $38 million - $41 million = $24 million

FCFE (per share) = FCFE / number of outstanding shares

= $24 million / 84 million shares

= $0.286

02

Calculation of current value of share

Since all of the components of FCFE are expected to grow at the same rate, the FCFE would be levied at the common rate.

Base Assumptions:

Shares outstanding: 84 millions

Required return on equity (r): 14%



Actual 2010

Projected 2011

Projected 2012

Projected 2013

Growth rate (g)

27%27%13%







Total

Per share




Earnings after tax

$80

$0.952

$1.2090

$1.5355

$1.7351

Plus Depreciation

$23

$0.274

$0.3480

$0.4419

$0.4994

Less Capital expenditure

$38

$0.452

$0.5740

$0.7290

$0.8238

Less Increase in net working capital

$41

$0.488

$0.6198

$0.7871

$0.8894

Equals FCFE

$24

$0.286

$0.3632

$0.4613

$0.5213

Terminal Value



$52.1300


Total cash to equity



$0.3632

$52.5913


Discounted value



$0.3186

$40.4673


Current value per share




$40.7859


03

Explanation of one shortcoming of two stage DDM model addressed and one not addressed by two stage FCFE model

i. Limitation addressed: While DDM cannot be used to estimate the value of a stock that pays no dividends the FCFE model recognizes the firm’s investment and financing policies as well as its dividend policy.

ii Limitation not addressed: Both two-stage valuation models share the same limitations with respect to the growth assumptions – an initial abnormal growth period followed by stable growth period.

Unlock Step-by-Step Solutions & Ace Your Exams!

  • Full Textbook Solutions

    Get detailed explanations and key concepts

  • Unlimited Al creation

    Al flashcards, explanations, exams and more...

  • Ads-free access

    To over 500 millions flashcards

  • Money-back guarantee

    We refund you if you fail your exam.

Start your free trial

Over 30 million students worldwide already upgrade their learning with Vaia!

One App. One Place for Learning.

All the tools & learning materials you need for study success - in one app.

Get started for free

Most popular questions from this chapter

Which of the following best explains a ratio of “net sales to average net fixed assets” that exceeds the industry average?.

a. The firm added to its plant and equipment in the past few years.

b. The firm makes less efficient use of its assets than other firms.

c. The firm has a lot of old plant and equipment.

d. The firm uses straight-line depreciation

If you believe the U.S. dollar is about to depreciate more dramatically than do other investors, what will be your stance on investments in U.S. auto producers?

Choose an industry and identify the factors that will determine its performance in the next three years. What is your forecast for performance in that period?

Chiptech, Inc., is an established computer chip firm with several profitable existing products as well as some promising new products in development. The company earned \(1 per share last year and just paid out a dividend of \).50 per share. Investors believe the company plans to maintain its dividend payout ratio at 50%. ROE equals 20%. Everyone in the market expects this situation to persist indefinitely

a. What is the market price of Chiptech stock? The required return for the computer chip industry is 15%, and the company has just gone ex-dividend (i.e., the next dividend will be paid a year from now, at t = 1).

b. Suppose you discover that Chiptech’s competitor has developed a new chip that will eliminate Chiptech’s current technological advantage in this market. This new product, which will be ready to come to the market in two years, will force Chiptech to reduce the prices of its chips to remain competitive. This will decrease ROE to 15%, and, because of falling demand for its product, Chiptech will decrease the plowback ratio to .40. The plowback ratio will be decreased at the end of the second year, at t = 2: The annual year-end dividend for the second year (paid at t = 2) will be 60% of that year’s earnings. What is your estimate of Chiptech’s intrinsic value per share?

( Hint: Carefully prepare a table of Chiptech’s earnings and dividends for each of the next three years. Pay close attention to the change in the payout ratio in t = 2.)

c. No one else in the market perceives the threat to Chiptech’s market. In fact, you are confident that no one else will become aware of the change in Chiptech’s competitive status until the competitor firm publicly announces its discovery near the end of year 2. What will be the rate of return on Chiptech stock in the coming year (i.e., between t = 0 and t = 1)? In the second year (between t = 1 and t = 2)? The third year (between t = 2 and t = 3)? ( Hint: Pay attention to when the market catches on to the new situation. A table of dividends and market prices over time might help.)

Use the following case in answering Problems 9– 11:

Hatfield Industries is a large manufacturingconglomerate based in the United States with annual sales in excess of $300 million.

Hatfield is currently under investigation by the Securities and Exchange Commission (SEC)for accounting irregularities and possible legal violations in the presentation of the company’sfinancial statements. A due-diligence team from the SEC has been sent to Hatfield’s corporateheadquarters in Philadelphia for a complete audit in order to further assess the situation.

Several unique circumstances at Hatfield are discovered by the SEC due-diligence teamduring the course of the investigation:

  • Management has been involved in ongoing negotiations with the local labor union, of which approximately 40% of its full-time labor force are members. Labor officials are seeking increased wages and pension benefits, which Hatfield’s management states is not possible at this time due to decreased profitability and a tight cash flow situation. Labor officials have accused Hatfield’s management of manipulating the company’s financial statements to justify not granting any concessions during the course of negotiations.
  • All new equipment obtained over the past several years has been established onHatfield’s books as operating leases, although past acquisitions of similar equipmentwere nearly always classified as capital leases. Financial statements of industry peersindicate that capital leases for this type of equipment are the norm. The SEC wantsHatfield’s management to provide justification for this apparent deviation from“normal” accounting practices.
  • Inventory on Hatfield’s books has been steadily increasing for the past few years incomparison to sales growth. Management credits improved operating efficiencies in itsproduction methods that have contributed to boosts in overall production. The SEC isseeking evidence that Hatfield somehow may have manipulated its inventory accounts.

The SEC due-diligence team is not necessarily searching for evidence of fraud but of possiblemanipulation of accounting standards for the purpose of misleading shareholders and otherinterested parties. Initial review of Hatfield’s financial statements indicates that, at a minimum,certain practices have resulted in low-quality earnings.

Question: Labor officials believe that the management of Hatfield is attempting to understate its netincome to avoid making any concessions in the labor negotiations. Which of the followingactions by management will most likely result in low-quality earnings?

a. Lengthening the life of a depreciable asset in order to lower the depreciation expense.

b. Lowering the discount rate used in the valuation of the company’s pension obligations.

c. The recognition of revenue at the time of delivery rather than when payment is received.
See all solutions

Recommended explanations on Business Studies Textbooks

Introduction to Business

Read Explanation

Managers

Read Explanation

Human Resources

Read Explanation

Business Development

Read Explanation

Influences On Business

Read Explanation

Strategic Direction

Read Explanation
View all explanations

What do you think about this solution?

We value your feedback to improve our textbook solutions.

Study anywhere. Anytime. Across all devices.

Sign-up for free