Mexican Motors’ market cap is 200 billion pesos. Next year’s free cash flow is 9
ID: 2731828 • Letter: M
Question
Mexican Motors’ market cap is 200 billion pesos. Next year’s free cash flow is 9.1 billion pesos. Security analysts are forecasting that free cash flow will grow by 8.1% per year for the next five years. a. Assume that the 8.1% growth rate is expected to continue forever. What rate of return are investors expecting? (Do not round intermediate calculations. Round your answer to 2 decimal places.)
Mexican Motors has generally earned about 9% on book equity (ROE = 9%) and reinvested 50% of earnings. The remaining 50% of earnings has gone to free cash flow. Suppose the company maintains the same ROE and investment rate for the long run. What will be the growth rate of earnings? (Do not round intermediate calculations. Round your answer to 1 decimal place.)
What would be the rate of return? (Do not round intermediate calculations. Round your answer to 2 decimal places.)
b-1.Mexican Motors has generally earned about 9% on book equity (ROE = 9%) and reinvested 50% of earnings. The remaining 50% of earnings has gone to free cash flow. Suppose the company maintains the same ROE and investment rate for the long run. What will be the growth rate of earnings? (Do not round intermediate calculations. Round your answer to 1 decimal place.)
b-2.What would be the rate of return? (Do not round intermediate calculations. Round your answer to 2 decimal places.)
Explanation / Answer
a. The constant growth formula P= DIV/(r g) can be used here:
$200 = $9.1/(r-.081)
Solving for r, r = 0.1265. That is, investors expect an 12.65% rate of return
b. Given the Mexican Motors is plowing back 50% of earnings after earning 9% on equity, the firm can expect to grow at an annual rate of only 4.5% (ROE x plowback = 0.09 x 0.50 = 0.045).
Applying the constant growth formula again and solving for r we get:
$200 = $9.1/(r-.045) r = 0.0905.
That is, investors should expect only a 9.05% rate of return.