Question

Amarindo, Inc. (AMR), is a newly public firm with 9.5 million shares outstanding. You are doing a valuation analysis of AMR. You estimate its free cash flow in the coming year to be $14.63 million, and you expect the firm's free cash flows to grow by 4.3 % per year in subsequent years. Because the firm has only been listed on the stock exchange for a short time, you do not have an accurate assessment of AMR's equity beta. However, you do have beta data for UAL, another firm in the same industry:

Table

Equity Beta 1.95

Debt Beta 0.39

Debt-Equity Ratio 1.3

      

AMR has a much lower debt-equity ratio of 0.39 , which is expected to remain stable, and its debt is risk free. AMR's corporate tax rate is 30 %, the risk-free rate is 5.3 %, and the expected return on the market portfolio is 11.4 %. a. Estimate AMR's equity cost of capital. b. Estimate AMR's share price.

Answer 1

UAL's data:

Equity Beta, Be = 1.95

Debt Beta, Bd = 0.39

Debt-Equity Ratio = D/E = 1.3

Wd = D / (D + E) = 1.3 / (1.3 + 1) = 56.52%

We = E / (D + E) = 1 - Wd = 1 - 56.52% = 43.48%

Asset Beta, Ba = Wd x Bd + We x Be = 56.52% x 0.39 + 43.48% x 1.95 = 1.0683

This will also be the asset beta of AMR

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AMR's data:

Debt is risk free, hence debt beta = Bd = 0

D/E = 0.39

Wd = D / (D + E) = 0.39 / (0.39 + 1) = 28.06%

We = 1 - Wd = 1 - 28.06% = 71.94%

Ba = Wd x Bd + We x Be

Or, 1.0683 = 28.06% x 0 + 71.94% x Be

Hence, Be = 1.0683 / 71.94% = 1.4849

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Part (a)

AMR's equity cost of capital = Ke = Rf + Be x (Rm - Rf) = 5.3% + 1.4849 x (11.4% - 5.3%) = 14.36%

Part (b)

Cost of debt, Kd = Risk free rate = 5.3%

WACC = r = Wd x Kd x (1 - T) + We x Ke = 28.06% x 5.3% x (1 - 30%) + 71.94% x 14.36% = 11.37%

Hence, value of the firm, V = C / (r - g) = 14.63 / (11.37% - 4.3%) = $ 206.92 milion

Hence, value fo equity = E = We x V = 71.94% x 206.92 = $ 148.87 million

N = 9.5 million shares outstanding

Hence, share price = E / N = 148.87 / 9.5 = $ 15.67