Question 4

L&T Corporation, a diversified technology company, in 2011, reported operating income of $100 million on book equity invested (at the beginning of the period) of $ 700 million. The firm faced a tax rate of 30%. The firm also reported capital expenditures of $140 million and depreciation of $100 million in 2011. Non-cash working capital increased by $10 million during the year. The firm has no other revenue and income, and therefore the net income of the firm in 2011 is $70 million. The stock has a beta of 1.50, but it drops to 1 after 2016.

After 2016, the firm enters into the stable growth period. The expected growth rate in net income will drop to 3% and the return on equity will drop to the cost of equity of the firm.

The Treasury bond rate is 3%, and the equity risk premium is 4%. There are 100 million shares outstanding. The firm’s corporate bonds were rated AA. [A typical large AA rated company had an interest coverage ratio of 6.75 and a default spread of 1.2%.]

(a) Estimate the after-tax return on equity and equity reinvestment rate in 2011;

(b) Estimate the expected growth rate for L&T from 2012 to 2016, assuming that the return on equity and equity reinvestment rate remain unchanged;

(c) Estimate the Free Cash Flow to Equity of L&T in each year from 2012 to 2016, assuming that the return on equity and equity reinvestment rate remain unchanged;

(d). Estimate the Free Cash Flow to Equity in 2017;

(e).Estimate the terminal value of L&T in the end of year 2016?

(f).Estimate the intrinsic price of L&T in the end of year 2011?