Q ? Grubb State Power and Light\'s free cash flow next year will be $100 million
ID: 2647201 • Letter: Q
Question
Q ? Grubb State Power and Light's free cash flow next year will be $100 million and it is widely expected to grow at a 4 percent annual rate indefinitely. The company's weighted average cost of capital is 10 percent, the market value of its liabilities is $1 billion, and it has 20 million shares outstanding.
a. Estimate the price per share of Grubb's common stock.
b. A private equity firm believes that by selling the company 767 airplane, increasing the work day to eight hours, and instituting other cost savings, it can increase Grubb's free cash flow next year to $110 billion and can add a full percentage point to Grubb's growth rate without affecting its cost of capital. What is the maximum price per share the private equity firm can justify bidding for control of Grubb?
Explanation / Answer
Q ? Grubb State Power and Light's free cash flow next year will be $100 million and it is widely expected to grow at a 4 percent annual rate indefinitely. The company's weighted average cost of capital is 10 percent, the market value of its liabilities is $1 billion, and it has 20 million shares outstanding.
a. Estimate the price per share of Grubb's common stock.
Firm Value = free cash flow next year/(weighted average cost of capital - growth rate)
Firm Value = 100/(10%-4%)
Firm Value = 1666.67 Million
Liabilty = 1000 Million
Equity Value = 666.67 Million
Price per share of Grubb's common stock. = 666.67/20
Price per share of Grubb's common stock. = $ 33.33
b. A private equity firm believes that by selling the company 767 airplane, increasing the work day to eight hours, and instituting other cost savings, it can increase Grubb's free cash flow next year to $110 million and can add a full percentage point to Grubb's growth rate without affecting its cost of capital. What is the maximum price per share the private equity firm can justify bidding for control of Grubb?
Firm Value = free cash flow next year/(weighted average cost of capital - growth rate)
Firm Value = 110/(10%-5%)
Firm Value = 2200 million
Liabilty = 1000 million
Equity Value = 1200 Million
Price per share of Grubb's common stock. = 1200/20
Price per share of Grubb's common stock. = $ 60
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