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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

CORPORATE VALUE MODEL Assume that today is December 31, 2015, and that the following information applies to Vermeil Airlines:

  • After-tax operating income EBIT (1–T) for 2016 is expected to be $500 million.
  • The depreciation expense for 2016 is expected to be $100 million.
  • The capital expenditures for 2016 are expected to be $200 million.
  • No change is expected in net operating working capital.
  • The free cash flow is expected to grow at a constant rate of 6% per year.
  • The required return on equity is 14%.
  • The WACC is 10%.
  • The market value of the company’s debt is $3 billion.
  • 200 million shares of stock are outstanding.

Using the corporate valuation model approach, what should be the company’s stock price today?

Summary Introduction

To identify: The price per share.

Corporate Value Model:

The model that evaluates a firm on the basis of its future operations and the results of those operations is called corporate valuation model. It is a useful tool to analyze a firm’s stock for investment purposes.

Explanation

Compute the free cash flows.

Given,

The earnings before interest and tax (EBIT)with tax is $500 million.

The depreciation is $100 million.

The capital expenditure is $200 million.

Formula to calculate the free cash flow,

Freecashflow=EBIT(1T)+DepreciationCapitalexpenditure

Where,

  • EBIT is earnings before interest and tax.
  • T is tax rate.

Substitute $500,000,000 for EBIT(1T), $100,000,000 for depreciation and $200,000,000 for capital expenditure.

Freecashflow=$500,000,000+$100,000,000$200,000,000=$600,000,000$200,000,000=$400,000,000

Therefore the free cash flow is $400,000,000.

Compute the intrinsic value.

The free cash flow is $400 million. (Calculated above)

The growth rate is 6% or 0.06.

The WACC is 10% or 0.10.

Formula to calculate the intrinsic value,

Intrinsicvalue=FreecashflowWACCg

Where,

  • WACC is weighted average cost of capital.
  • G is growth rate.

Substitute $400,000,000 for free cash flows, 0.06 for growth rate and 0

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