3. (20 points) Hot Pockets Corporation is considering going public. Managers wan

Question

3. (20 points) Hot Pockets Corporation is considering going public. Managers want to estimate common stock value. The standard deviation of returns for this firm is 20%. The firm’s beta is 0.8. 3-month T-Bills currently trade at a discount to par of 1% on an annualized basis. The expected return on the stock market is 10%. There are 10,000 shares of common stock outstanding. Assume the firm’s capital structure is 50% debt, 50% common equity, the cost of debt is 6%, and the marginal tax rate for the firm is 21%.

a) What is the total risk of this firm, and what is its systematic risk?

b) What is the expected return of this stock? What is the name of the model you use to estimate it?

c) What is the Weighted Average Cost of Capital for the firm?

d) If the firm’s estimated free cash flows over the next 3 years are:

Year       Estimated Free Cash Flow

2018       $100,000

2019       $200,000

2020       $300,000

and after 2020 to infinity, expected free cash flows will grow at a rate of 4% per year: (i) what is the value of its equity outstanding; and (ii) what would be the price per share?

e) (i) If an investor in Hot Pockets owns equal amounts of Hot Pockets, Nextera Energy, Southwest Airlines, and Caterpillar common stock, what will the market risk of his/her portfolio be? (Assume standard deviation of 10%, 30%, and 25%, and beta of .5, 1.5, and 1 for each of Nextera Energy, Southwest Airlines, and Caterpillar common stock.) (ii) Given the above information, what will be the percentage return on this investor’s portfolio if the market goes up 10%?

Explanation / Answer

a) Total Risk of the firm =20% Systematic risk is 80% b) This modal is called Capital Asset Pricing Model (CAPM) As per CAPM Risk free rate+ beta(market risk-Risk free rate) 1%+0.8(10%-1%) 8.20% c) Weighted Average cost of capital cost of debt*weight of debt+ cost of equity*weight of equity 6%*50%+ 8.2*50% 7.10% d) Present value of equity after 2020 $300000(1.04)/7.1%-4% 100,64,516.00 Value OF Firm 100000/1.071        93,370.00 Add 200000/(1.071*^2)     1,74,361.00 300000/(1.071^3)     2,44,204.00 10064516/(1.071^3) 81,92,651.00 Value OF Firm 87,04,586.00 Price per share 8704586/No of Shares $87.04

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