Question
1.) Paccolin is a start-up company with a cost of equity capital of 10% per annum. It is 100% equity financed. Assume for simplicity that
1.) Paccolin is a start-up company with a cost of equity capital of 10% per annum.
It is 100% equity financed. Assume for simplicity that it pays no taxes.
It is now the end of 2021. It is predicted that Paccolins sales revenue will be
GBP () 400,000 in the year 2022, and that sales growth rates in 2023 to 2027
will be as follows:
Year | 2023 | 2024 | 2025 | 2026 | 2027 |
Sales growth (%) | 50% | 40% | 25% | 10% | 4% |
Assume that operating expenses always equal 50% of sales; and that, starting at 80,000 in year 2021, net operating working capital always equals 20% of the following years sales.
The carrying amount of net non-current operating assets (in 000) will be as follows:
End of year | 2021 | 2022 | 2023 | 2024 | 2025 | 2026 |
Net non-current operating assets | 2,000 | 2,100 | 2,200 | 2,300 | 2,400 | 2,500 |
a) Calculate Paccolins expected free cash flow to equity (FCFE) in 2022 to 2026.
(5 marks)
b) Assuming that Paccolins free cash flow to equity grows at 4.85% in 2027 and then at 4% in the post-horizon period from 2028 onwards, and given that there are 1 million shares outstanding, calculate the intrinsic value of a share in Paccolin at the end of 2021.
(5 marks)
c) Explain under what assumptions one might arrive at a prediction of a long-term FCFE growth rate of 4% for the post-horizon period.
(3 marks)
d) What proportion of the value of equity you calculated in part (b) is due to FCFE expected in the post-horizon period? Comment on this. To what extent would this be different if you had used a different valuation method?
(3 marks)
e) By how much would the share price you calculated in part (b) change if the assumed
post-horizon growth rate (i) increased, or (ii) decreased by 1%? Explain briefly what additional considerations or methods would help you to arrive at a more precise estimate of the value of Paccolins equity.
(6 marks)
f) Explain the drawbacks of using the dividend discount model or free cash flow based models when valuing a young company with positive expected net present value (NPV) investment opportunities and heavy investment in operating assets.
(3 marks)
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