A firm’s total annual dividend payout is $1 million. Its stock price is $45 per

Question

A firm’s total annual dividend payout is $1 million. Its stock price is $45 per share and it has 17,500,000 shares outstanding. The firm earned $4 million in Net Income last year. This year, the firm expects earnings to grow at 7%, with growth the year after that expected to be 5%, and then in all following years, the firm expects earnings to grow at 3%. The firm plans to hold their dividend payout ratio constant over the coming 20 years and beyond. The risk free rate is 3%, beta for the entire firm is 1.3, and the equity risk premium is 7.75%. What is the value of equity for the entire firm using the FREE CASH FLOW model, using Net Income as free cash flow?

Explanation / Answer

Cost of equity, r = Rf + beta x RP = 3% + 1.3 x 7.75% = 13.08%

Value of equity = FCF1 / (1 + r) + FCF2 / (1 + r)^2 + FCF3 / (r - g) x (1 + r)^2

Here, FCF1 = 4 x (1 + 7%) = 4.28 million, FCF2 = 4.28 x (1 + 5%) = 4.49 million, FCF3 = 4.49 x (1 + 3%) = 4.63 million

=> Value of equity = 4.28 / (1 + 13.08%) + 4.49 / (1 + 13.08%)^2 + 4.63 / (13.08% - 3%) x (1 + 13.08%)^2

=> Value of equity = $43.23 million

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