Mexican Motor's market cap is 200 billion pesos. Next year's cash flow is 8.6 billion pesos. Security analyst are forecasting that free cash flow will grow by 7.60% per year for the next five years.a. Assume that the 7.60 growth rate is expected to continue forever. What rate of return are investors expecting?b1. Mexican Motors has generally earned about 10% on book equity (ROE= 10%) and reinvested 50% of earnings. The remaining 50% of earnings has gone to free cash flow. Suppose the company mantians the same ROE and investment rate for the long run. What will be the growth rate of earnings?b2. What would be he rate of return?

Question
Asked Jun 15, 2019

Mexican Motor's market cap is 200 billion pesos. Next year's cash flow is 8.6 billion pesos. Security analyst are forecasting that free cash flow will grow by 7.60% per year for the next five years.

a. Assume that the 7.60 growth rate is expected to continue forever. What rate of return are investors expecting?

b1. Mexican Motors has generally earned about 10% on book equity (ROE= 10%) and reinvested 50% of earnings. The remaining 50% of earnings has gone to free cash flow. Suppose the company mantians the same ROE and investment rate for the long run. What will be the growth rate of earnings?

b2. What would be he rate of return?

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Expert Answer

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Step 1

Mexican Motor's market cap, E = 200 billion pesos.

Next year's cash flow, C =  8.6 billion pesos.

Security analyst are forecasting that free cash flow will grow by g = 7.60% per year for the next five years.

Step 2

Part a.

Under the assumption that the 7.60 growth rate is expected to continue forever, this becomes the terminal growth rate.

Let, Ke be the rate of return that investors are expecting.

Then, based on Gordan growth model, we get hthe following relationship:

E = C / (Ke - g)

Hence, 200 = 8.6 / (Ke - 7.60%)

Hence, Ke = 8.6 / 200 + 7.60% = 11.90%

Step 3

Hence, the rate of return expected b...

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