03 Oct Golden Enterprises Inc. is a producer of medical pumps. The companys stock price dropped 15% last year due to worsening financial ratios and declining market share. The company is insolve
Golden Enterprises Inc. is a producer of medical pumps. The company’s stock price dropped 15% last year due to worsening financial ratios and declining market share. The company is insolvent because its liabilities exceed the market value of its assets, and it does not have enough cash to meet its interest and principal payments. The stockholders are worried and threatening to vote out the management of the company and replace them with new ones. The board of directors of the company has asked the Chief Finance Officer, Christopher Valentine, MBA to address certain concerns as an outside group is soliciting proxies to overthrow management and take control of the business. The board wants to know how much the company is worth, what can be done to make the company more valuable, why stock price of the company is so volatile, and if it is possible to stop the outside group from taking over the business.
1. Explain the following terms to the management of Golden Enterprises:
i. proxy fight
ii. preemptive right
2. Identify and explain two main sources of entity value.
3. The most recent free cash flow (FCF) for Golden Enterprises was $200 million, and the management expects the free cash flow to begin growing immediately at a 7% constant rate. The cost of capital is 12%.
i. Using the constant growth model, determine the value of operations for Golden Enterprises Inc.
Golden Enterprises Inc. balance sheet shows that it has $10 million short-term investments, $15 million in notes payable, $60 million in long-term bonds, and $15 million in preferred stock. Golden Enterprises has 60 million of shares outstanding. Calculate the following:
ii. total intrinsic value for Golden Enterprises Inc.
iii. intrinsic value of equity for Golden Enterprises Inc.
iv. intrinsic stock price per share for Golden Enterprises Inc.
4. Another company in the medical equipment industry, Watkins Inc. is expected to have free cash flow (FCF) of $105 million next year and an expected constant growth rate of 5% thereafter. The weighted average cost of capital (WACC) for the company is 9.0%. Using the constant growth model, estimate the value of operations for Watkins Inc.
5. Golden Enterprises Inc. is expected to pay a $4.50 per share dividend at the end of this year (i.e., D1 = $4.50). The dividend is expected to grow at a constant rate of 5% a year. The required rate of return on the stock is, rs, is 9.2%. Using the constant dividend growth model, what is the estimated value per share of the company’s stock?
6. Golden Enterprises has preferred stock outstanding that pays a dividend of $5 at the end of each year. The preferred stock sells for $50 a share. Calculate the preferred stock’s required rate of return.
7. Boehm Incorporated currently pays a dividend of $2 per share (D0 = $2). It is estimated that the company’s dividend will grow at a rate of 20% per year for the next 2 years and then at a constant rate of 7% thereafter. The company’s stock has a beta of 1.2, the risk-free rate is 7.5%, and the market risk premium is 4%. Calculate the estimated current price of the stock.
Submit your answers in a Word document.
Corporate Valuation and Stock Valuation
CHAPTER 7
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Topics in Chapter
Features of common stock
Valuing common stock
Dividend growth model
Free cash flow valuation model
Market multiples
Preferred stock
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Corporate Valuation and Stock Valuation
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Common Stock: Owners, Directors, and Managers
Represents ownership.
Ownership implies control.
Stockholders elect directors.
Directors hire management.
Since managers are “agents” of shareholders, their goal should be: Maximize stock price.
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Classified Stock
Classified stock has special provisions for each class, usually involving voting rights and dividend rights.
Usually named Class A, Class B, etc.
New shares in IPO sometimes have voting restrictions but full dividend rights.
Founders’ shares usually have voting rights but dividend restrictions.
Standard & Poor’s no longer allows new additions to its indices to have classified stock.
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Tracking Stock
The dividends of tracking stock are tied to a particular division, rather than the company as a whole.
Investors can separately value the divisions.
Its easier to compensate division managers with the tracking stock.
But tracking stock usually has no voting rights, and the financial disclosure for the division is not as regulated as for the company.
Very few companies have tracking stock.
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Different Approaches for Valuing Common Stock
Free cash flow model
Constant growth
Nonconstant growth
Dividend growth model
Constant growth
Nonconstant growth
Using the multiples of comparable firms
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The Free Cash Flow Valuation Model: FCF and WACC
Free cash flow (FCF) is:
The cash flow available for distribution to all of a company’s investors.
Generated by a company’s operations.
The weighted average cost of capital (WACC) is:
The overall rate of return required by all of the company’s investors.
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Value of Operations (Vop)
The PV of expected future FCF, discounted at the WACC, is the value of a company’s operations (Vop):
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Sources of Value
Value of operations
Nonoperating assets
Short-term investments and other marketable securities
Ownership of non-controlling interest in another company
Value of nonoperating assets usually is very close to figure that is reported on balance sheets.
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Claims on Corporate Value
Debtholders have first claim.
Preferred stockholders have the next claim.
Any remaining value belongs to stockholders.
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Total Corporate Value: Sources and Claims
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Value of operations= PV of FCF discounted at WACC
Conceptually correct, but how do you find the present value of an infinite stream?
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Suppose FCFs are expected to grow at a constant rate, gL, starting at t=1, and continue forever. What happens to FCF?
What is the value of operations if FCFs grow at a constant rate? See next slide.
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Value of operations in terms of FCF1 and gL:
We can multiply and divide by (1+gL), for a reason that will soon be clear, as shown on the next slide.
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Rewritten value of operations:
We can group , as shown on the next slide.
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Value of operations with grouped terms:
We can group the terms, as shown on the next slide.
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Value of operations if FCF grows at a constant rate:
What happens toif t gets large? It depends on the size of gL relative to WACC. See next slide.
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What happens to as t gets large?
If gL < WACC: Then < 1.
If gL ≥ WACC: Then ≥ 1.
What happens to the value of operations if gL ≥ WACC? See next slide.
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What happens to the value of operations if gL ≥ WACC?
Vop = (Big) + (Bigger) + (Even Bigger) + …+ (Really big!) = Infinity! So g can’t be greater than or equal to WACC!
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What happens to the value of operations if gL ≤ WACC?
Vop = (Small) + (Smaller) + (Even smaller) + …+ FCF0 (Really small!) = ?
All the terms get smaller and smaller, but what happens to the sum? See next slide
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What is the sum of an infinite number of factors that get smaller at a geometric rate?
Consider this example. The first row is t. The second row is a number that is less than 1 that is compounded to the power of t. The third row is the cumulative sum.
| t | 1 | 2 | 3 | 4 | . . . ∞ |
| (1/2)t | 1/2 | 1/4 | 1/8 | 1/16 | 1/∞ ≈ 0 |
| Σ(1/2)t | 1/2 | 3/4 | 7/8 | 15/16 | ≈ 1 |
This sum converges to 1. Similarly, converges (although not to 1). See next slide.
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Constant Growth Formula for Value of Operations: gL begins at Time 1
If FCF are expected to grow at a constant rate of gL from Time 1 and afterwards, and gL<WACC:
This is the PV of all FCF from Time 1 through infinity, when discounted at WACC.
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Constant Growth Formula for Value of Operations: gL begins at Time 0
If FCF are expected to grow at a constant rate of gL from Time 0 and afterwards, and gL<WACC:
This is still the PV of all FCF from Time 1 through infinity, when discounted at WACC.
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Data for FCF Valuation
FCF0 = $24 million
WACC = 11%
FCF is expected to grow at a constant rate of gL = 5%
Short-term investments = $100 million
Debt = $200 million
Preferred stock = $50 million
Number of shares =n = 10 million
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Find Value of Operations
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Total Value of Company (VTotal)
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Estimated Intrinsic Value of Equity (VEquity)
| Voperations | $420.00 |
| + ST Inv. | 100.00 |
| VTotal | $520.00 |
| −Debt | 200.00 |
| − Preferred Stk. | 50.00 |
| VEquity | $270.00 |
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Estimated Intrinsic Stock Price per Share, (1 of 2)
| Voperations` | $420.00 |
| + ST Inv. | 100.00 |
| VTotal | $520.00 |
| −Debt | 200.00 |
| − Preferred Stk. | 50.00 |
| VEquity | $270.00 |
| n | 10 |
| $27.00 |
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Expansion Plan: Nonconstant Growth
Finance expansion financed by owners.
Projected free cash flows (FCF):
Year 1 FCF = −$10 million.
Year 2 FCF = $20 million.
Year 3 FCF = $35 million
FCF grows at constant rate of 5% after year 3.
No change in WACC, marketable securities, debt, preferred stock, or number of shares of stock.
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Estimating the Value of Operations
Free cash flows are forecast for three years in this example, so the forecast horizon is three years.
Growth in free cash flows is not constant during the forecast, so we can’t use the constant growth formula to find the value of operations at time 0.
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Time Line of FCF
| Year | 0 | 1 | 2 | 3 | 4 | 5 | … t |
| FCF | −$10 | $20 | $35 | FCF3(1+gL) | FCF4(1+gL) | FCFt(1+gL) |
Free cash flows are forecast for three years in this example, so the forecast horizon is three years.
Growth in free cash flows is not constant during the forecast, so we can’t use the constant growth formula to find the value of operations at time 0.
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Horizon Value
| Year | 0 | 1 | 2 | 3 | 4 | 5 | … t |
| FCF | FCF3(1+gL) | FCF4(1+gL) | FCFt(1+gL) | ||||
| HV3 | ← ↵ | ← ↵ | ← ↵ |
Horizon value is also called terminal value, or continuing value.
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Horizon Value Application (FCF3 = $35, WACC = 11%, gL = 5%)
This is the value of FCF from Year 4 and beyond discounted back to Year 3.
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Value of Operations at t=0: PV of FCF1 through FCF3 plus PV of HV3
| Year | 0 | 1 | 2 | 3 | 4 | 5 | … t |
| FCF | FCF1 | FCF2 | FCF3 | ||||
| PV of FCF in explicit forecast | ← ↵ | ← ↵ | ← ↵ | FCF3(1+gL) | FCF4(1+gL) | FCFt(1+gL) | |
| + | HV3 | ← ↵ | ← ↵ | ← ↵ | |||
| PV of HV | ← ↵ | ← ↵ | ← ↵ | ||||
| = Value of operations Time 0 |
PV of HV is the PV of FCF beyond the explicit forecast. So PV of HV plus PV of FCF in explicit forecast is the PV of all future FCFs.
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Application: Current Value of Operations (Nonconstant g in FCF until after Year 3; gL = 5%; WACC = 11%)
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Estimated Intrinsic Stock Price per Share, (2 of 2)
| Voperations | $480.67 |
| + ST Inv. | 100.00 |
| VTotal | $580.67 |
| −Debt | 200.00 |
| − Preferred Stk. | 50.00 |
| VEquity | $330.67 |
| ÷ n | 10 |
| $33.07 |
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How much of the value of operations is based on cash flows from Year 4 and beyond?
The horizon value is the value of all FCF from Year 4 and beyond, discounted back to Year 3.
The present value of HV3 is the present value of all FCF from Year 4 and beyond.
The PV of HV3 is the percent of total value due to long-term cash flows.
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Value of Operations and Present Value of Horizon Value
Value of operations: Vop = $480.67
Horizon value: HV3 = $612.5
PV of HV3 = $612.5/(1 + 0.11)3
= $447.855
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Percent of Value Due to Long-Term Cash Flows
In this example, 93% of value is due to cash flows 4 or more years into the future.
For the average company, this percentage is around 80%.
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Long-term versus Short-term Focus
Why focus on quarterly earnings if most value is from longer-term cash flows?
Changes in quarterly earnings can signal changes future in cash flows. This would affect the current stock price.
Managers often have bonuses tied to quarterly earnings, so they have incentive to manage earnings.
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Forecasting Free Cash Flows: A Si
