Hot Pockets Corporation is considering going public. Managers want to estimate c
ID: 2620387 • Letter: H
Question
Hot Pockets Corporation is considering going public. Managers want to estimate common stock value. The standard deviation of returns for this firm is 20%. The firm’s beta is 0.8. 3-month T-Bills currently trade at a discount to par of 1% on an annualized basis. The expected return on the stock market is 10%. There are 10,000 shares of common stock outstanding. Assume the firm’s capital structure is 50% debt, 50% common equity, the cost of debt is 6%, and the marginal tax rate for the firm is 21%.
a) What is the total risk of this firm, and what is its systematic risk?
b) What is the expected return of this stock? What is the name of the model you use to estimate it?
c) What is the Weighted Average Cost of Capital for the firm?
d) If the firm’s estimated free cash flows over the next 3 years are:
Year Estimated Free Cash Flow
2018 $100,000
2019 $200,000
2020 $300,000
and after 2020 to infinity, expected free cash flows will grow at a rate of 4% per year: (i) what is the value of its equity outstanding; and (ii) what would be the price per share?
e) (i) If an investor in Hot Pockets owns equal amounts of Hot Pockets, Nextera Energy, Southwest Airlines, and Caterpillar common stock, what will the market risk of his/her portfolio be? (Assume standard deviation of 10%, 30%, and 25%, and beta of .5, 1.5, and 1 for each of Nextera Energy, Southwest Airlines, and Caterpillar common stock.) (ii) Given the above information, what will be the percentage return on this investor’s portfolio if the market goes up 10%?
Explanation / Answer
A-
total return
standard deviation of the company
20%
systematick risk
Beta of the company
0.8
B-
expected return of stock - risk free rate+(market return-risk free rate)*beta
1+(10-1)*.8
8.2
It uses capital asset pricing model
C-
after tax cost of debt
6*(1-.21)
4.74
cost of common stock
8.2
WACC
source
weight
cost
weight*cost
debt
0.5
4.74
2.37
common stock
0.5
8.2
4.1
WACC
6.47
D-
Year
expected cash flow
1
100000
2
200000
3
300000
4
312000
terminal value of stock = expected free cash flow in year 4/ (WACC-growth rate)
(312000/8.2%-4%)
3804878
Year
expected cash flow
present value of cash flow = expected cash flow/(1+wacc)^n wacc = 6.47%
1
100000
93923.17
2
200000
175671.4
3
300000
246960.8
3
3804878
3132186
present value of equity outstanding
3648741
value per share
3648741/10000
364.8741
e-i
market risk of portfolio
security
weight
beta
weight*beta
H
0.25
0.8
0.2
N
0.25
0.5
0.125
S
0.25
1.5
0.375
C
0.25
1
0.25
Beta of portfolio
sum of weight*beta
0.95
e-2
Percentage return on portfolio if market up by 10%
10*0.95
9.5
A-
total return
standard deviation of the company
20%
systematick risk
Beta of the company
0.8
B-
expected return of stock - risk free rate+(market return-risk free rate)*beta
1+(10-1)*.8
8.2
It uses capital asset pricing model
C-
after tax cost of debt
6*(1-.21)
4.74
cost of common stock
8.2
WACC
source
weight
cost
weight*cost
debt
0.5
4.74
2.37
common stock
0.5
8.2
4.1
WACC
6.47
D-
Year
expected cash flow
1
100000
2
200000
3
300000
4
312000
terminal value of stock = expected free cash flow in year 4/ (WACC-growth rate)
(312000/8.2%-4%)
3804878
Year
expected cash flow
present value of cash flow = expected cash flow/(1+wacc)^n wacc = 6.47%
1
100000
93923.17
2
200000
175671.4
3
300000
246960.8
3
3804878
3132186
present value of equity outstanding
3648741
value per share
3648741/10000
364.8741
e-i
market risk of portfolio
security
weight
beta
weight*beta
H
0.25
0.8
0.2
N
0.25
0.5
0.125
S
0.25
1.5
0.375
C
0.25
1
0.25
Beta of portfolio
sum of weight*beta
0.95
e-2
Percentage return on portfolio if market up by 10%
10*0.95
9.5
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