1. KimberlyClark, a household product manufacturer, reported earnings per share

Question

1. KimberlyClark, a household product manufacturer, reported earnings per share of  3.2 $ in 2014 and paid dividends per share of $1.7  in that year. The firm reported depreciation of $315 million in 2014 and capital expenditures of $475 million. (There were 160 million shares outstanding).  This ratio of capital expenditures to depreciation is expected to be maintained in the long term. The working capital needs are negligible. Kimberly-Clark will maintain a debt ratio of 16.39%. The firm is in steady state and earnings are expected to grow 7% a year. The stock had a beta of 1.05. (The Treasury bond rate is 6.25%. and the market risk premium 5.5%)

a. Estimate the value per share, using the Dividend Discount Model.

b. Estimate the value per share, using the FCFE Model.

c. How would you explain the difference between the two models and which one would you use as your benchmark for comparison to the market price?

Explanation / Answer

Part A)

The formula for calculating value per share with the use of dividend discount model is:

Value Per Share = Current Dividend*(1+Growth Rate)/(Required Return - Growth Rate)

Required Return (CAPM Model) = Risk Free Rate + Beta*Market Risk Premium

___________

Using the values provided in the question, we get,

Required Return = 6.25% + 1.05*5.5% = 12.025%

Value Per Share = 1.70*(1+7%)/(12.025% - 7%) = $36.20

_________________________

Part B)

Free cash flow will be calculated with the use of earnings per share and adjustment for desired debt fraction. Since, the working capital needs are negligible, we will ignore its impact in the calculation of free cash flow. The formula for calculation free cash flow can be derived as follows:

Free Cash Flow = EPS - (1-Desired debt Fraction)*(Capital Expenditure - Depreciation)/Total Shares Outstanding

The formula for calculating value per share would be:

Value Per Share = Free Cash Flow*(1+Growth Rate)/(Required Return - Growth Rate)

Required Return (CAPM Model) = Risk Free Rate + Beta*Market Risk Premium

___________

Using the values provided in the question, we get,

Required Return = 6.25% + 1.05*5.5% = 12.025%

Free Cash Flow = 3.20 - (1-16.39%)*(475-315)/160 = $2.36

Value Per Share = 2.36*(1+7%)/(12.025% - 7%) = $50.20

_________________________

Part C)

The difference in the 2 models is on account of the fact that value of free cash flow ($2.36) is greater than the value of dividends ($1.70). Higher value derived from FCFE model indicates the extra value resulting from accumulation of additional cash in the firm. It is therefore, advisable to use FCFE model as the benchmark as it represents a more accurate and true value per share, when compared to the market price.

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