Covan Inc. is expected to have the following free cash flows: Year 1 2 3 4 p FCF 10 12 13 14 Grow

QUESTION

Covan, Inc., is expected to have the following free cash flows: Year 1 2 3 4 p FCF 10 12 13 14 Grow by 4% per year a. Covan has 8 million shares outstanding, $3 million in excess cash, and it has no debt. If its cost of capital is 12%, what should its stock price be? b. Covan reinvests all its FCF and has no plans to add debt or change its cash hold- ings. If you plan to sell Covan at the beginning of year 2, what should you expect its price to be? c. Assume you bought Covan stock at the beginning of year 1. What is your return expected to be from holding Covan stock until year 2?
Solution Given: CF1 = $10 million CF2 = $12 million CF3 = $13 million CF4 = $14 million Terminal growth rate, g = 4% No. of shares = 8 million Cash = $3mn Debt = 0 Cost of capital, r = 12% Workings Solution to part a. Terminal value (at the end of year 4) = CF4*(1+g)/(r-g) = 14*(1+4%)/(12%-4%) Terminal value = $182 million Enterprise value = CF1/(1+r)^1 + CF2/(1+r)^2 + CF3/(1+r)^3 + CF4/(1+r)^4 + TV/(1+r)^4 Enterprise value (EV) = 10/(1+12%)^1 + 12/(1+12%)^2 + 13/(1+12%)^3 + 14/(1+12%)^4 + 182/(1+12%)^4 = $ 152.31 million Equity value (EQ) = EV debt +cash EQ = 152.31-0+3 = $155.31 million Equity value per share = EQ/no. of shares = 155.31/8 = $19.41 Solution to part b. The value of Covan at the beginning of year 2 is same as the value at the end of year 1. To analyse this, we need to consider the original cash flow at year 2 as the cash flow at year 1 and so on. Therefore, in this case- CF1 = $12 million CF2 = $13 million CF3 = $14 million Terminal value (at the end of year 3) = CF3*(1+g)/(r-g) = 14*(1+4%)/(12%-4%) Terminal value = $182 million

rprise value = CF1/(1+r)^1 + CF2/(1+r)^2 + CF3/(1+r)^3 + TV/(1+r)^3 Enterprise value (EV) = 12/(1+12%)^1 + 13/(1+12%)^2 + 14/(1+12%)^3 + 182/(1+12%)^3 = $ 146.71 million Equity value (EQ) = EV debt +cash Cash at the end of year 1 = cash at year 0 + cash flows during year 1 Therefore, Cash at the end of year 1 = 3 + 10 = 13 EQ = 146.71-0+13 = $159.71 million Equity value per share = EQ/no. of shares = 159.71/8 = $19.96 Solution to part c Assume you bought Covan stock at the beginning of year 1. What is your return expected to be from holding Covan stock until year 2? Value of stock at beginning of year 1 = 19.41 Value of stock at beginning of year 2 = 19.96 The rate of return is 19.96/19.41-1 = 2.8%

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