Covan, Inc. is expected to have the following free cash flow: Year FCF 2 4 12 14
ID: 2784943 • Letter: C
Question
Covan, Inc. is expected to have the following free cash flow: Year FCF 2 4 12 14 1516 Grow by 3% per year a. Covan has 8 million shares outstanding, $4 million in excess cash, and it has no debt. If its cost of capital is 12%, what should be its stock price? b. Covan reinvests all its FCF and has no plans to add debt or change its cash holdings (it does not invest its cash holdings). If you plan to sell Covan at the beginning of year 2, what is its expected price? c. Assume you bought Covan stock at the beginning of year 1. What is your expected return from holding Covan stock until year 2?Explanation / Answer
a. In order to find out the stock price, we will have to find out the present value of future cash flows. By using 12% as the cost of capital, we get:
Year 1 - 12 * 1/1.12^1 = 10.71
Year 2 - 14 * 1/1.12^2 = 11.61
Year 3 - 15 * 1/1.12^3 = 10.68
Year 4 - 16 * 1/1.12^4 = 10.17
Year 5 onwards - 16 (1.03)/0.12-0.03 = 183.11
By adjusting this for the cost of capital in year 5, we get 183.11/1.12^5 = 103.90
The present value of future cash flows is $147.07m.
Now, excess cash would be deducted from this amount to calculate enterprise value, but since we are calculating theoretical market capitalisation, we will not use that.
The stock price can be calculated as 147.07/8 = $18.38 per share.
b. Now consider the beginning of year 2 as year 0. The future cash flows that can arise from it are calculated as follows:
Year 1 - 14/1.12^1 = 12.5
Year 2 - 15/1.12^2 = 11.96
Year 3 - 16/1.12^3 = 11.39
Year 4 above)/1.12^4 = 116.36
The total present value of future cash flows is: $152.21m
Deducting the excess cash from this we get: $148.21m.
This is the enterprise value of the company, the expected price when selling the company.