Barrett Industries invests a large sum of money in R & D; as a result, it retains and reinvests all of its earnings. In other words, Barrett does not pay any dividends and it has no plans to pay dividends in the near future. A major pension fund is interested in purchasing Barrett's stock. The pension fund manager has estimated Barrett's free cash flows for the next four years as follows: $3 million, $6 million, $10 million, and $15 million. After the fourth year, free cash flow is projected to grow at a constant 7% Barrett's WACC is 12%, its debt and preferred stock total $60 million, and it has 10 million shares of common stock outstanding. Required: a) Determine Barrett's enterprise value b) Estimate Barrett's price per share of common stock.
Growth rate after 4 years = 7%
Cash flow for year 5 = $15,000,000*1.07 = $16,050,000
WACC = 12%
Value of free cash flows after year 4 at the end of 4 = $16,050,000 / (0.12-0.07)
= $16,050,000 / 0.05
= $321,000,000
Free cash flow for year 4 = $15,000,000+321,000,000 = $336,000,000
Year 1 2 3 4
Total free cash flow $3,000,000 $6,000,000 $10,000,000 $336,000,000
PVIF12% 0.8929 0.7972 0.7118 0.6355
PV of free cash flow $2,678,571 $4,783,163 $7,117,802 $213,534,074
PV $228,113,612
Enterprise value = Market capitalization - Cash and equivalents + Debt + Preferred stock
= $228,113,612 + 60,000,000 = $288,113,612
To determine Barrett's enterprise value, we need to calculate the present value of its free cash flows, and add it to the market value of its debt and preferred stock.
Step 1: Calculate the present value of free cash flows.
Year 1: $3 million / (1 + 0.12)^1 = $2.68 million
Year 2: $6 million / (1 + 0.12)^2 = $4.88 million
Year 3: $10 million / (1 + 0.12)^3 = $6.80 million
Year 4: $15 million / (1 + 0.12)^4 = $9.82 million
Step 2: Calculate the present value of the terminal value.
Terminal value = Year 5 free cash flow / (WACC - Terminal growth rate)
Year 5 free cash flow = Year 4 free cash flow * (1 + Terminal growth rate) = $9.82 million * (1 + 0.07) = $10.52 million
Terminal value = $10.52 million / (0.12 - 0.07) = $210.4 million
Step 3: Calculate the present value of the cash flows.
PV of cash flows = $2.68 million + $4.88 million + $6.80 million + $9.82 million + $210.4 million / (1 + 0.12)^4 = $172.78 million
Step 4: Calculate the market value of debt and preferred stock.
Market value of debt and preferred stock = $60 million
Step 5: Calculate the enterprise value.
Enterprise value = PV of cash flows + Market value of debt and preferred stock = $172.78 million + $60 million = $232.78 million
Therefore, Barrett's enterprise value is $232.78 million.
To estimate Barrett's price per share of common stock, divide the enterprise value by the number of shares of common stock outstanding.
Price per share = Enterprise value / Number of shares of common stock
Price per share = $232.78 million / 10 million shares = $23.28
Therefore, Barrett's estimated price per share of common stock is $23.28.
To determine Barrett's enterprise value, we need to calculate the present value of its projected free cash flows and add the value of its debt and preferred stock. The formula for enterprise value is as follows:
Enterprise Value = Present Value of Free Cash Flows + Value of Debt + Value of Preferred Stock
a) Let's calculate the present value of the projected free cash flows. We will use the formula for the present value of a growing perpetuity:
Present Value = Cash Flow / (Discount Rate - Growth Rate)
Year 1:
Present Value of Free Cash Flow in Year 1 = $3 million / (1 + 0.12)^1 = $2.68 million
Year 2:
Present Value of Free Cash Flow in Year 2 = $6 million / (1 + 0.12)^2 = $4.46 million
Year 3:
Present Value of Free Cash Flow in Year 3 = $10 million / (1 + 0.12)^3 = $6.32 million
Year 4:
Present Value of Free Cash Flow in Year 4 = $15 million / (1 + 0.12)^4 = $9.05 million
Now we need to calculate the present value of the cash flow starting from the fifth year, taking into account the constant 7% growth rate:
Present Value of Terminal Value = Cash Flow / (Discount Rate - Growth Rate)
Terminal Value = $15 million * (1 + 0.07) / (0.12 - 0.07)
Terminal Value = $15 million * 1.07 / 0.05 = $321 million
Finally, we can calculate the present value of the projected free cash flows:
Present Value of Free Cash Flows = Present Value of Year 1 + Present Value of Year 2 + Present Value of Year 3 + Present Value of Year 4 + Present Value of Terminal Value
Present Value of Free Cash Flows = $2.68 million + $4.46 million + $6.32 million + $9.05 million + $321 million
Present Value of Free Cash Flows = $343.51 million
b) Now that we have the present value of the projected free cash flows, we can estimate Barrett's price per share of common stock. To do this, we will divide the enterprise value by the number of common shares outstanding:
Price per Share of Common Stock = (Enterprise Value - Value of Debt - Value of Preferred Stock) / Number of Common Shares Outstanding
Price per Share of Common Stock = ($343.51 million - $60 million) / 10 million
Price per Share of Common Stock = $28.35
Therefore, Barrett's estimated price per share of common stock is $28.35.