Question

Your employer, a mid-sized human resources management company, is considering expansion into related fields, including the acquisition of Temp Force Company, an employment agency that supplies word processor operators and computer programmers to businesses with temporary heavy workloads. Your employer is also considering the purchase of Biggerstaff & McDonald (B&M), a privately held company owned by two friends, each with 5 million shares of stock. B&M currently has free cash flow of $24 million, which is expected to grow at a constant rate of 5%. B&M’s financial statements report short-term investments of $100 million, debt of $200 million, and preferred stock of $50 million. B&M’s weighted average cost of capital (WACC) is 11%. Answer the following questions.

1.   Describe briefly the legal rights and privileges of common stockholders.

2.   What is free cash flow (FCF)? What is the weighted average cost of capital? What is the free cash flow valuation model?

3.   Use a pie chart to illustrate the sources that comprise a hypothetical company’s total value. Using another pie chart, show the claims on a company’s value. How is equity a residual claim?

4.   Suppose the free cash flow at Time 1 is expected to grow at a constant rate of forever. If, what is a formula for the present value of expected free cash flows when discounted at the WACC? If the most recent free cash flow is expected to grow at a constant rate of forever (and), what is a formula for the present value of expected free cash flows when discounted at the WACC?

Using complete sentences and academic vocabulary, please answer questions 1 thru 4. Please don't copy from other sources. Thank you

Answer 1

1-   Legal rights of common stock holders                       
    1- Common stock holders can participate in annual general meetings 2- They have voting right 3- They have right in residual profit 4- They have a decision making powers                       
2-   Free cash flow refers to the cash flow available after meeting out all the expenses, taxes, net changes in working capital and any capital expenditure. Free cash flow refers to cash that is available with the company without any liability for the distribution to shareholders                       
    Free cash flow = cash flow from operations + any change in working capital -capital expenditure                       
    Weighted average cost of capital refers to the minimum required rate of return which a company should earn, this is the least rate of return which a company should earn for its survival.                       
    Free cash flow valuation model when growth rate is constant for forever   current Year free cash flow*(1+growth rate) / (WACC-growth rate)                    
                           
3-   Source   market value of source                    
    bonds   500000                    
    common stock   4000000                    
    preferred stock   250000                    
    retained earning   250000                    
    total market value   5000000                    
                           

                          
                           
                           
                           
                           
                           
                           
                           
                           
                           
                           
3-b   Debt   500000   10%                 
    equity   4500000   90%                 
    total   5000000                    
                           
    Debt   10%                    
    equity   90%                    
    total   100%                    
                           

                          
                           
                           
                           
                           
                           
                           
                           
                           
                           
                           
                           
    Equity is a residual claim because dividend is distributed after the fixed financial commitments and also in the case of liquidation they get payment is last.                       
                           
4-   terminal value of stock = expected free cash flow/(WACC-growth rate)                       
    present value of free cash flow = expected free cash flow/(1+r)^1 + terminal value/(1+r)                       
                           
4-2   present value of free cash flow = current free cash flow*(1+r)/(1+r)^1 + terminal value/(1+r)