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1 Stuart, Inc. reported net income of $20 million for last year. Depreciation ex

ID: 2722553 • Letter: 1

Question

1 Stuart, Inc. reported net income of $20 million for last year. Depreciation expense totaled $15 million and capital expenditures came to $5 million. Free cash flow is expected to grow at a rate of 6% for the foreseeable future. Stuart faces a 40% tax rate and has a 0.30 debt to equity ratio with $75 million (market value) in debt outstanding. Stuart's equity beta is 1.1, the risk-free rate is currently 6% and the market risk premium is estimated to be 8.0%. What is the current value (in millions) of Stuart's equity?

Explanation / Answer

The equity value can be calculated with the use of following formula:

Equity Value = Firm Value - Market Value

where Firm Value = Free Cash Flow*(1+Growth Rate)/(Required Return - Growth Rate)

where Required Return = Risk Free Rate + Beta of Asset*Market Risk Premium

where Beta of Asset = Beta of Equity/(1+Debt Equity Ratio*(1-Tax Rate))

__________

Using the information provided in the question, we get,

Beta of Asset = 1.1/(1+.30*(1-40%)) = .93

Required Return = 6 + .93*8 = 13.44%

Firm Value = (20 + 15 - 5)*(1+6%)/(13.44% - 6%) = $427.42

Equity Value = 427.42 - 75 = $352.42