Estimate the value of equity, by discounting the cash flows to equity at the cost of equity.

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February 5, 2021
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February 5, 2021

Estimate the value of equity, by discounting the cash flows to equity at the cost of equity.

Exercise 1 You have been asked to value a firm with expected annual after-tax cash flows, before debt payments, of $100 million a year in perpetuity. The firm has a cost of equity of 10%, a market value of equity of $750 million and a market value of debt of $500 million (this is also the book value). The debt is perpetual and the after-tax interest rate on debt is 5%. The company has no non-operating activities.

a. Estimate the value of the firm and the value of the equity based upon this value.

b. Estimate the value of equity, by discounting the cash flows to equity at the cost of equity.

c. Now assume that you had been told that the market value of equity was $850 million and that all of the other information remained unchanged. Answer parts a and b, using these new values.

d. In practice, what needs to happen for the two valuation approaches (FCFF and FCFE) to give the same estimate of value?

Exercise 2 a. Using the financial statements and other information that you have for MPR, and assuming a 5% perpetual growth rate in the FCFE, value the equity using the FCFE method.

b. Does this value equal the estimated value using the FCFF method? Why or why not?

Exercise 3 IO Taxes Inc. is a large but privately-held all-equity firm in the tax planning industry. The firm has been enjoying a nice 20% annual growth in its FCFE due to the highly anticipated increase in taxes related to the massive baby-boomers retirement wave. IO’s FCFE is expected to be $5 million next year. The growth rate is expected to be the same for an additional year after that and then management expects the FCFE’s growth rate to cool down to 4% in perpetuity.

IO Taxes has 10 million shares outstanding and it has $10 million in non-operating cash (invested mostly in Treasury bills).

While IO Taxes is not publicly traded, its close competitor, H&R Rock Inc., is and has an unlevered and unadjusted equity beta of 1.3.

Additional market information:

Market risk premium: 5.2%

T-bond yield: 2.25%

a. Based on the available information, please estimate IO’s cost of equity.

b. Estimate the intrinsic value of each share of stock.


 

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