Reading 47: Free Cash Flow Valuation - LOS k ～ Q19-20

答案和详解如下：

19.Starshah Industries competes in a high-growth, emerging technology sector that is facing increasing competitive pressures. So far, the firm has been performing well, earning $4.55 per share in 2004. Investment requirements were high, with capital expenditures of $1.75 per share, depreciation expense of $1.05, and a net investment in working capital that year of $1.00 per share. However, despite Starshah’s high growth rate and impressive profitability, Starshah’s Chairman, Lorenzo di Stefano, has become concerned about the impact that a slowdown in expected growth may have on the firm’s valuation.

Di Stefano asked Starshah’s Director of Strategic Planning, Keisha Simmons, to make a presentation to Starshah’s board at the end of 2004 about the future growth of the firm. The news was sobering. Simmons told the board members that Starshah could expect two more years of rapid growth, during which time earnings per share could be expected to rise 45 percent per year with 30 percent annual increases in capital spending and depreciation. During this high-growth period, Simmons estimates that the required return on equity for Starshah will be 25 percent. Starshah consistently maintains a target debt ratio of 0.25.

After the near-term spurt of high growth, however, she and her group expect Starshah to move eventually to a stable growth period. During the stable growth period, free cash flow to equity (FCFE) will rise only 5 percent per year and the annual return to shareholders will decline to 10 percent.

The strategy group expects the transitional period between high-growth and mature growth to last five years. During that time, capital expenditures will rise only 8 percent per year, with depreciation rising 13 percent per year. The growth in earnings should drop by eight percentage points per year, hitting 5 percent in the fifth year. During this transition, the expected return to shareholders will be 15 percent per year.

Throughout the high-growth and transitional growth periods, Simmons expects Starshah to be able to limit increases in the investment in working capital to 20 cents per year. In her analysis, the investment in working capital will peak in 2010, declining a dime to $2.10 per share in 2011.

After Simmons’ presentation, the board debated what to do about the incipient slowdown in Starshah’s growth. A majority of the board argued in favor of moving to offset this slowdown in organic growth through a new emphasis on growth by acquisition.

One potential target is TPX. TPX is expected to have fairly strong free cash flow to equity (FCFE) for the next few years: $425,000 in 2004, $500,000 in 2005, $600,000 the following year, and $700,000 in 2007. After that, Starshah expects free cash flow to equity at TPX to grow 3 percent per year indefinitely. Starshah would require a return on its equity investment of 20 percent per year in the high-growth stage and 12 percent per year in the stable growth stage.

Di Stefano and Simmons had a somber meeting the day after the board presentation. But despite the bleak news about future years, di Stefano had convinced himself it was worth staying around through the high-growth and transitional periods. He pointed out to Simmons that, if Simmons’ projections were correct, the value of Starshah’s stock would be in excess of $450 per share by the time the company hit the stable-growth phase. Di Stefano was very pleased with what that implied for the value of his stock options.

Simmons had done the same calculations herself, but she also realized that if required rates of return in 2012 rose from the very modest 10 percent she used in her board projections to only 15 percent, that would cut the terminal value of Starshah’s stock in 2011 to only half the level di Stefano was counting on. She considered that valuation too small to make the wait worthwhile. Simmons said nothing to di Stefano, but planned to look for another job.

Which of the following free cash flow to equity (FCFE) models is best suited to analyzing TPX?

A)   Stable growth FCFE model.

B)   Three-stage FCFE model.

C)   Two-stage FCFE model.

D)   FCFE Perpetuity model.

The correct answer was C)

The two-stage FCFE model is most suited to analyzing TPX because we have specific forecasts for the first several years and then a stable growth pattern into the indefinite future.

20.The free cash flow to equity (FCFE) for Starshah at the end of the transition period in 2011 is closest to:

A)   $20.62.

B)   $23.42.

C)   $21.89.

D)   $27.52.

The correct answer was C)

In order to calculate FCFE for Starshah in 2011, we need to construct a table of the components of cash flow for Starshah.

We are given the 2004 values for net income, capital expenditures, depreciation, and change in working capital. We are also given growth rates for each of the three stages of Starshah’s growth: high-growth for two years followed by transitional growth for five years, culminating in stable growth for the following years. Using the original values and their related growth rates, plus the formula for FCFE (see below), we can construct the following table:

FCFE = Earnings per share - (Capital Expenditures - Depreciation) x (1 - Debt Ratio) – (Change in working capital x (1 - Debt Ratio)) = 24.27 – (4.35 – 3.27) x (1-0.25) – (2.10 x (1-0.25))
= 24.27 – 0.81 – 1.57 = 21.89
Free cash flow to equity equals $21.89 per share in 2011.