At the end of the year 2004 the Office Equipment Industry had free cash flow to

Question

At the end of the year 2004 the Office Equipment Industry had free cash flow to equity (FCFE) of $2.50 per share. The following annual growth rates in FCFE are projected:

2005 10%
2006 15%
2007 20%
2008 25%
2009 20%
2010 15%
2011 10%
2012 7%

From year 2013 onward growth in FCFE is expected to remain constant at 5% per year. The industry has a beta of 0.90 and the current industry price is $105. Currently the yield on 10-year Treasury notes is 5% and the equity risk premium is 4%


1. Calculate the required rate of return on equity.

2. Calculate the present value now (Year 2004) of FCFE during the period of increasing growth (that is for years 2005 to 2008).

3. Calculate the present value now (Year 2004) of FCFE during the period of declining growth (that is for years 2009 to 2012).

4. Calculate the present value now (Year 2004) of FCFE during the period of constant growth (that is for years 2013 onwards).

5. Calculate the intrinsic value of the industry now (Year 2004).

Explanation / Answer

PART - A

Ke = RF + Beta ( RM-RF)

= 0.05+0.90 (4) Rm-Rf =4

= 8.6%

PART - B

Present value now 2005 to 2008 Increasein growth (1+ growth rate)

Cash flow = 2.50(1.10)(1.15)(1.20)(1.25)

   = 4.74375

PART - C

Present Value of 2009 to 2012 ( Declining Growth so (1- Growth Rate)

Cash flow = 4.74375(0.80)(0.85)(0.90)(0.93)

   = 2.7000

PART - D

Present Value of 2013 (Constant Growth)

Cash flow = 2.70(1.05)

   =2.835

PART - E

Intrinsic Value of Industry now

Cash flow = Cashflow/Ke-g

   = 2.835/0.086-0.05

   = 78.75

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