Case study 1

Part a.

You are an investment adviser. One of your clients approaches you for your advice on investing in equity shares of Theta Company. You have collected the following data:

Earnings per share at the end of the previous year $20.00 Retention ratio 0.60 Return on equity 0.10 Cost of equity capital 0.15

The company plans to decrease the retention ratio to .40 from year 4.

Required:

i) Estimate the price of an equity share of this company using the two-period dividend discount model and advise your client whether they should buy a share of the company.

ii) Your client is keen to know whether there are any growth opportunities from their investment. Explain to your client the meaning of this concept using appropriate calculations.

iii) If there are positive or negative growth opportunities, explain the reason for such opportunities.

Part b.

You are a senior financial analyst of a firm based in Sydney. You have been assigned the task of training interns who recently joined your firm on how to use the free cash flow model to estimate the value of a company. You have collected data on the following data:

year	2021	2022	2023
Long-term debt ($M)	150,000	155,000	149,000
Interest long-term debt ($M)	9,000	10,850	9685
Working capital	21,500	24,000	26,000
EBIT ($M)	145,000	155,000	157,000
Capital expenditure	43,500	46,500	47,100
Depreciation	72,500	77,500	78,500
Cost of equity		0.10	0.12
WACC		0.13	0.14
Number of equity shares (Million)	4,000
Terminal growth rate	0.06
Tax rate	0.30

Free cash flow to the firm

Free cash to equity

Value of the firm according to the free cash flow to firm method

Value of the firm according to the free cash flow to equity method

Estimated price of an equity share according to the free cash flow to the firm method and

the free cash flow to equity method

Note: For parts i and ii prepare a table showing how free cash flow to firm and free cash flow to equity are calculated.