Problem I . As an alternative to last week\'s Discussion Question on HMK\'s meth

Question

Problem I. As an alternative to last week's Discussion Question on HMK's method of raising $10M in bonds to fund its capital expansion projects, as an alternative HMK has decided to look at equity financing.

Equity financing can be either the use of retained earnings from the right-hand side of the balance sheet (with the corresponding assets being short-term investments in current assets, or very large amounts in the cash account in current assets, or the disposal of other less efficient longer-term assets), or in the current case, the issuance of new common stock to finance the investment. But, in order to “get at” the cost of this new common stock equity, you have to review a few fundamentals with Mr. Moneypockets first.

you note that HMK has just paid an annual dividend of $1.50. Analysts are predicting the dividend to grow by $0.12 per year over the next five years. After then, HMK’s earnings are expected to grow by 6% per year, and its dividend payout rate will remain constant. If HMK’s cost of capital (which is what we are eventually seeking for the overall weighted average cost of capital) is assumed to be 8.5% by you, what price will you tell Mr. Moneypockets that HMK stock should be selling for today, using the dividend-discount model as your technique?

b. alternatively, you expect free cash flows to be generated over the next five years as follows for HMK:

Year          1                          2                         3                   4                  5

FCF ($M) 53                         68                      78                 75                82

After then, you expect the free cash flows to grow at the industry average of 6% per year (same rate as the growth in dividends after the first five years, per above).

If you now switch to the discounted free cash flow model as an alternative, and use the same estimate of 8.5% as the equity cost of capital:

--what will you tell Mr. Moneypockets that his “enterprise value” will be for HMK?

--if HMK has no excess cash that can be used for this investment, but already has $300M of debt (none of which includes Option I debt financing above), and 40M shares outstanding of common stock, what will be your estimate of the stock price to Mr. Moneypockets?

c. what conclusions can you give Mr. Moneypockets relative to the differing stock price estimates that might result from these two approaches to stock price estimation? What could account for the differences in the two stock price approaches?  

d. If the price of the stock is roughly $62 when issued (and assuming no flotation costs such as paid to an Investment Banker), how many shares of new stock will have to be issued in the primary market to major investors such as CalPERS (California Pension Fund System) and the AFL-CIO Pension Fund, in order to raise the $10M??

Explanation / Answer

(A). Current dividend i.e dividend at t=0 is $1.50. And as per growing dividends dividends in future are:

At t=6 considering the 6% growth rate we get the terminal value = 2.10*(1.06) / (0.085-0.06) = 89.04. Now we find PV of all the future dividends = $ 66.47.

(B). For the terminal value of FCF at t=6 is 82*(1.06) / (0.085-0.06) = $3476.8 mn. Now the PV of all future cash flows = $ 2588.56 mn. This is the enterprise value. Now this is the total value of the enterprise i.e Market Value. And debt = $300 mn. So the market value of equity = $ 2288.56 with 40 mn shares outstanding. So share price = $57.21

(c). The major difference is due to two different measures undertaken for valuation. Dividends are more related to returns that investors are expecting and FCF consists of interests of all the stakeholders. FCF has a broad spectrum for analysis, and also Dividends are not paid by all the companies so I think FCF approach is better in general. So I think $ 57.21 is more accurate. Moreover ignorance of debtors

(d). As price when issued was $62. But now for the new stock price we are taking is $57.21 and $10mn has to bbe raised. So shares to be issued are 174,795 shares roughly.

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