Your employer, a mid-sized human resources management company, is considering ex

Question

Your employer, a mid-sized human resources management company, is considering expansion
into related fields, including the acquisition of Temp Force Company, an employment
agency that supplies word processor operators and computer programmers to businesses
with temporary heavy workloads. Your employer is also considering the purchase of Biggerstaff
& McDonald (B&M), a privately held company owned by two friends, each with
5 million shares of stock. B&M currently has free cash flow of $24 million, which is expected
to grow at a constant rate of 5%. B&M’s financial statements report short-term investments
of $100 million, debt of $200 million, and preferred stock of $50 million. B&M’s weighted
average cost of capital (WACC) is 11%. Answer the following questions.
a. Describe briefly the legal rights and privileges of common stockholders.
b. What is free cash flow (FCF)? What is the weighted average cost of capital? What is the
free cash flow valuation model?
c. Use a pie chart to illustrate the sources that comprise a hypothetical company’s total
value. Using another pie chart, show the claims on a company’s value. How is equity a
residual claim?
d. Suppose the free cash flow at Time 1 is expected to grow at a constant rate of gL
forever. If gL<WACC, what is a formula for the present value of expected free cash
flows when discounted at the WACC? If the most recent free cash flow is expected to
grow at a constant rate of gL forever (and gL<WACC), what is a formula for the
present value of expected free cash flows when discounted at the WACC?
e. Use B&M’s data and the free cash flow valuation model to answer the following questions.

(1) What is its estimated value of operations?
(2) What is its estimated total corporate value? (This is the entity value.)
(3) What is its estimated intrinsic value of equity?
(4) What is its estimated intrinsic stock price per share?
f. You have just learned that B&M has undertaken a major expansion that will change
its expected free cash flows to $10 million in 1 year, $20 million in 2 years, and
$35 million in 3 years. After 3 years, free cash flow will grow at a rate of 5%. No new
debt or preferred stock was added; the investment was financed by equity from the
owners. Assume the WACC is unchanged at 11% and that there are still 10 million
shares of stock outstanding.
(1) What is the company’s horizon value (i.e., its value of operations at Year 3)? What
is its current value of operations (i.e., at Time 0)?
(2) What is its estimated intrinsic value of equity on a price-per-share basis?
g. If B&M undertakes the expansion, what percent of B&M’s value of operations at Year
0 is due to cash flows from Years 4 and beyond? (Hint: Use the horizon value at t 3
to help answer this question.)
h. Based on your answer to the previous question, what are two reasons why managers
often emphasize short-term earnings?

i. Your employer also is considering the acquisition of Hatfield Medical Supplies. You have
gathered the following data regarding Hatfield, with all dollars reported in millions:
(1)most recent sales of $2,000; (2) most recent total net operating capital,OpCap $1,120;
(3) most recent operating profitability ratio, OP NOPAT Sales 4 5%; and (4) most
recent capital requirement ratio, CR OpCap Sales 56%. You estimate that the
growth rate in sales fromYear 0 to Year 1 will be 10%, fromYear 1 to Year 2 will be 8%,
from Year 2 to Year 3 will be 5%, and from Year 3 to Year 4 will be 5%. You also
estimate that the long-term growth rate beyond Year 4 will be 5%. Assume the
operating profitability and capital requirement ratios will not change. Use this
information to forecast Hatfield’s sales, net operating profit after taxes (NOPAT),
OpCap, free cash flow, and return on invested capital (ROIC) for Years 1 through 4.
Also estimate the annual growth in free cash flow for Years 2 through 4. The weighted
average cost of capital (WACC) is 9%. How does the ROIC in Year 4 compare with
the WACC?
j. What is the horizon value at Year 4? What is the total net operating capital at Year 0?
How does the value of operations compare with the current total net operating
capital?

Explanation / Answer

Part a. Legal Rights and Privilieges

The common stockholders are owners of an organisation and hence they certain rights and privileges which include:

1. Ownership refers to control and it gives right to nominate and appoint Board of Directors who in turn will have right to appoint managers and staff to operate business.

2. They also possess preemtive right to purchase additional sales of the firm when they are offered on sale. In certain cases, these rights are part of company Charter, but in case of others such rights need to included specifically.

Part b. Free Cash Flow, WACC and FCFF valuation model

Free Cash Flow are surplus cash flow available for distribution to all stakeholders of the company. This also represent Cash Flow From Operations net of Capital Expenditures.

Weighted Average Cost of Capital or WACC, as it is commonly known as, is the rate of return on investment required by the investors (debt + equity + preference) of the firm. It is an important parameter to evaluate projects or value a firm. To arrive at present value of free cash flow to firm, WACC is used as a discounting factor. Further in case of new project review, WACC is used a decision making tool. If internal rate of return (IRR) from the project is more than WACC, then the project is economically viable and hence should be pursued for investment.

Free Cash Flow Valuation model refers to use of free cash flow to firm to value the firm. In this model, free cash flows are calculated using future projection of income and expenditure. Subsequently, WACC is used to discount the future free cash flow to arrive at a present value of free cash flow. The sum of present values of all these free cash flows gives us the fair value of firm.

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