Covan, Inc. is expected to have the following free cash flow: Covan has 8 millio

Question

Covan, Inc. is expected to have the following free cash flow: Covan has 8 million shares outstanding, $3 million in excess cash, and it has no debt. If its cost of capital is 11%, what should be its stock price? Covan reinvests all its FCF and has no plans to add debt or change its cash holdings (it does not invest its cash holdings). If you plan to sell Covan at the beginning of year 2, what its expected price? Assume you bought Covan stock at the beginning of year 1. What is your expected return from holding Covan stock until year 2?

Explanation / Answer

Answer (a)

Answer (b)

Answer (c)

FCF5 = FCF4*(1+g) FCF5 = 15*(1+0.04) FCF5 = 15.6 Terminal Value : 15.6/(Ke-g) Terminal Value : 15.6/(0.11-0.04) = 222.85714 Value of Firm (V0) = CF1/(1+r)^1 + CF2/(1+r)^2 + CF3/(1+r)^3 + CF4/(1+r)^4 + TV/(1+r)^4 Value of Firm (V0) = 11*(1+0.11)^1 + 13/(1+0.11)^2 + 14/(1+0.11)^3 + 15/(1+0.11)^4 + 222.85714/(1+0.11)^4 Value of Firm (V0) = (11*0.90090) + (13*0.81162)+ (14*0.73119) + (15*0.65873) + (222.85714*0.65873) Value of Firm (V0) = 187.38 Total Firm Value (V0) = 187.38 Equity = Firm Value- Debt+Cash Equity = 187.38-0+3 = 190.38 No of Shares = 8 millions Stock Price: 190.38 millions/8 millions = $23.7975

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