R30 - Free Cash Flow Valuation - EOC Q6.

CFA Level II Equities
#1
  1. Quinton Johnston is evaluating NYL Manufacturing Company, Ltd. In 2017, when Johnston is performing his analysis, the company is unprofitable. Furthermore, NYL pays no dividends on its common shares. Johnston decides to value NYL Manufacturing by using his forecasts of FCFE. Johnston gathers the following facts and assumptions:
  • The company has 17.0 billion shares outstanding.
  • Sales will be $5.5 billion in 2018, increasing at 28 percent annually for the next four years (through 2022).
  • Net income will be 32 percent of sales.
  • Investment in fixed assets will be 35 percent of sales; investment in working capital will be 6 percent of sales; depreciation will be 9 percent of sales.
  • 20 percent of the net investment in assets will be financed with debt.
  • Interest expenses will be only 2 percent of sales.
  • The tax rate will be 10 percent. NYL Manufacturing’s beta is 2.1; the risk-free government bond rate is 6.4 percent; the equity risk premium is 5.0 percent.
  • At the end of 2022, Johnston projects NYL terminal stock value at 18 times earnings.
    What is the value of one ordinary share of NYL Manufacturing Company?

I understand all of this answer provided in the text except for the initial formula used to derive the answer.

FCFE= NI− (1−DR)(CapEx − Deprec)−(1−DR)(InvWC)

Is some super smart person out there able to derive/explain/rearrange this formula so it makes a bit more sense and resembles one of the formulas provided in the text?

Thanks so much :slight_smile:

#2

FCFE=NI+Dep-fc.inv- wc. Inv+ net borrowings

Net borrowing= DR(FC inv- dep+ wc inv)

FCFE= NI+ Dep - FC inv - wc inv + DR ( FC inv- dep +wc inv)

FCFE= NI - (FC inv- dep)+ DR ( FC inv- dep) - wc+ (DR)wc inv

FCFE= NI- (1-DR)(FC-dep)- (1-DR)wc

#3

This is great thanks so much.

I am still a little confused on the final step.

Going from:

FCFE= NI - (FC inv- dep)+ DR ( FC inv- dep) - wc+ (DR)wc inv

to

FCFE= NI- (1-DR)(FC-dep)- (1-DR)wc

Are you able to explain this or show further detail?

Thanks again

#4

Just rearrange… I can rewrite it as

FCFE= NI- [(FCinv - Dep)- DR(FC inv- dep)] note we have taken “-” out of the bracket.

Now as FC inv - dep is common, take them out and this term can thn be rewritten as (1-DR)(FC inv - dep). U can do similar jugglery for working cap.

Hope this clarifies.