AAS Inc. paid the last year dividend of 7 USD per share while EPS was 10 USD. Re
ID: 2807399 • Letter: A
Question
AAS Inc. paid the last year dividend of 7 USD per share while EPS was 10 USD. Return on equity was 25% and will be stable in the near future. Payout ratio is expected to increase linearly until it will level off at 80% in year 4. Financial department expects that return on equity will decrease to 15% starting from year 4. Risk-free rate is 10%. Return on the market portfolio is 20%. AAS has also attracted perpetual debt with annual interest payment of 1 USD per share at the beginning of this year to pay compensation for the lost lawsuit. Covariance between market index and AAS shares return is 10%, standard deviation of the market portfolio return is 25%. Corporate tax rate is 20%.
1. Determine intrinsic value of the stock.
2. Determine present value of growth opportunities and value of assets in place.
3. Is it possible for a firm to show positive free cash flows but be in trouble? Explain.
Explanation / Answer
Growth rate = ROE*RR= = 0.25*0.20= 0.05 or 5
For perpetuity after 4th year.
Ke= 15 from year 4
Beta of stock= covariance is security, market/ variance of market= 0.10/(0.25)2= 1.6
RR= 10+(20-10)*1.6= 26
Growth for 4 years = 8-7/7*100= 14.285/4= 3.57
Intrinsic value of stock can be calculated as:
P0= 7.25/(1.26) + 7.508/(1.26)^2+ 7.776/(1.26)^3 + 8.05/(1.26)^4+ 8.05*(1.05)/(0.15- 0.05)*(1.26)^4=
P0= 51.09$
2. Present value of growth opportunities=
stock price - earnings /ke
51.09- 10/0.26= 12.628$
Value of Assets in place= E1/R + PVGO= 10/0.26+ 12.628= 51.09$
3. Even if the company have positive free cash flows, they can have negative income because the depreciation and other non cash charges are deducted from income statement but gets added back at the time of computing free cash flows hence the company can be in trouble even after positive free cash flows as it may have negative income.