Chapter 9, Problem 20P

Fundamentals of Financial Manageme...

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

Chapter
Section

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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