River Enterprises has $500 million in debt and 20 million shares of equity outstanding. Its excess cash reserves are $15 million. They are expected to generate $200 million in free cash flows next year with a growth rate of 2% per year in perpetuity. River Enterprises’ cost of equity capital is 12%. After analyzing the company, you believe that the growth rate should be 3% instead of 2%. How much higher (in dollars) would the price per share of stock be if you are right?
Free cash flow to equity = 200 Mn growing at 2% in perpetuity
Value of equity = FCFE (1)/ (Ce -g) = 200/(12%-2%) = 200/0.1 = 2000 Mn
If growth rate is 3%, value of equity = 200/(12%-3%) = 200/0.09 = 2222.22 Mn
a. Value of stock = (2000 +15)/20 = 100.75 (15 Mn is free cash reserve availble for distibution to stock holders)
b. value of stock with 3% = 2237.22/20 = 111.86
Thus stock price would be higher by = b-a = 11.11$
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