You have an option to buy Jack Clothing Corporation stocks. Based on the release

Question

You have an option to buy Jack Clothing Corporation stocks. Based on the released financial statements, they have $500 million of debt and 14 million shares of stock outstanding. You expect the Corporation to generate the following cash flows over the next five years: Year 1 2 3 4 5 FCF($millions) 75 84 96 111 120 Beginning with year six, you estimate that the Corporation's free cash flows will grow at 6% per year and that their weighted average cost of capital is 15%. Would you be willing to buy a share at the price $39? And why or why not? Please show the equations and work of how answer was obtained.

Explanation / Answer

WACC(weighted average cost of capital) = (cost of debt (Kd) * debt) / debt + equity+

cost of equity(Ke) * equity/equity + debt

equity = 14million * 39 = $546million

debt = $500million

debt + equity = 1046million

15% = Kd * 500/1046 + Ke * 546/1046

since nothing was given assuming cost of debt to be borrowed at risk free rate and risk free rate is 8%

on solving above sum we get Ke = 21.42%

YEAR CASHFLOWS DISC.FACTOR (21.42%) DISCOUNTED CASHFLOW

1 75 0.823 61.725

2 84 0.678 56.952

3 96 0.5586 53.62

4 111 0.46 51.06

5 120 0.378 45.36

6* 778 0.312 242.73

total 511.447million

511.447million / 14million = 36.53

note:-

FCFE6   = ( FCFF5 / Ke - g ) = (120 / 21.42 - 6 ) = $778.2million

based on above info share is over valued. hence should not be bought.

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