Your employer, a mid-sized human resources management company, is considering expansion into related fields, including the acquisition of Temp Force Company, an employment agency that supplies word processor operators and computer programmers to businesses with temporary heavy workloads. Your employer is also considering the purchase of a Bigger staff & McDonald (B&M), a privately held company owned by two friends, each with 5 million shares of stock. B&M currently has free cash flow of $24 million, which is expected to grow at a constant rate of 5%. B&M’s financial statements report marketable securities of $100 million, debt of $200 million, and preferred stock of $50 million. B&M’s weighted average cost of capital (WACC) is 11%. Answer the following questions.
- Describe briefly the legal rights and privileges of common stockholders.
The common stockholders are the owners of a corporation, and as such, they have certain rights and privileges as described below;
- Ownership implies control. Thus, a firm’s common stockholders have the right to elect its firm’s directors, who in turn elect the officers who manage the business.
- Common stockholders often have the right, called the preemptive right, to purchase any additional shares sold by the firm. In some states, the preemptive right is automatically included in every corporate charter; in others, it is necessary to insert it specifically into the charter.
- What is free cash flow (FCF)? What is the weighted average cost of capital? What is the free cash flow valuation model?
Free cash flow (FCF) is the cash which is generated by the business after accounting for or taking care of the firm’s capital expenditure including machines, equipment and buildings among other long term assets. This can be utilized for business expansion and paying dividends and debts.
The weighted average cost of capital (WACC) is the proportion of returns on investment which every investor is expected to get required to receive from the company. WACC comprises of all the kinds of capital such as common stock, bonds and preferred stock. If WACC increases then the valuation is likely to decrease which translates to an increase in business risks. The WACC is calculated to determine the cost of raising funds to purchase the long-term assets such as buildings, equipment and inventory.
Non-operating assets are the assets owned by the company but not utilized on the daily operations of the company. They are also known as redundant assets. They include marketable securities, vacant land and accounts receivables among others.
- Use a pie chart to illustrate the sources that comprise a hypothetical company’s total value. Using another pie chart, show the claims on a company’s value. How is equity a residual claim?
The total corporate value is the value of both operating and non-operating assets of the company. It represents the total worth of the firm. The funds set aside for growth options are in insignificant amount for this company. The debt holders are usually given the first claim of the assets followed by the preferred stockholders. The remaining assets are usually distributed to the remaining shareholders.
- Suppose the free cash flow at Time 1 is expected to grow at a constant rate of gL
a) If gL< WACC, what is a formula for the present value of expected free cash flows when discounted at the WACC?
b) If the most recent free cash flow is expected to grow at a constant rate of gL forever (and gL< WACC), what is a formula for the present value of expected free cash flows when discounted at the WACC?
- Use B&M’s data and the free cash flow valuation model to answer the following questions
(2) What is its estimated total corporate value?
Total corporate value = Vop + Short-term investments.
= $420 + $100
= $520 million
(3) What is its estimated intrinsic value of equity?
Intrinsic value of equity = Total value- Debt – Pref.
= $520 – $200 – $50
= $270 million
(4) What is its estimated intrinsic stock price per share?
Intrinsic stock price per share = Value of equity / Number of shares
= $270 / 10 – $200 – $50