Using the free cash flow valuation model to price an IPO - Assume that you have an opportunity to buy the stock of CoolTech, Inc., an IPO being offered for $12.50 per share. Although you are very much interested in owning the company, you are concerned about whether it is fairly priced. To determine the value of the shares, you have decided to apply the free cash flow valuation model to the firm's financial data that you've developed from a variety of data sources. The key values you have compiled are summarized in the following table.
Free cash flow
Year (t) FCFt Other data
2016 $ 700,000 Growth rate of FCF, beyond 2019 to infinity 5 2%
2017 800,000 Weighted average cost of capital 5 8%
2018 950,000 Market value of all debt 5 $2,700,000
2019 1,100,000 Market value of preferred stock 5 $1,000,000
Number of shares of common stock outstanding 5 1,100,000
a. Use the free cash flow valuation model to estimate CoolTech's common stock value per share.
b. Judging on the basis of your finding in part a and the stock's offering price, should you buy the stock?
c. On further analysis, you find that the growth rate in FCF beyond 2019 will be 3% rather than 2%. What effect would this finding have on your responses in parts a and b?

b. Since the Stock's offering price of $12.50 is higher than the estimated CoolTech's common stock value per share of $11.77, you should NOT buy the stock because it is currently overvalued.

c. Since the Stock's offering price of $12.50 is lower than the estimated CoolTech's common stock value per share of $14.41, you should buy the stock because it is currently undervalued.

Explanation:

Note: The data in this question are merged together and contain some errors. See the attached pdf for the complete sorted correct question.

The explanation of the answers is now given as follows:

a. Use the free cash flow valuation model to estimate CoolTech's common stock value per share.

Note: See part a of the attached excel file for the estimation of CoolTech's common stock value per share (in bold red color).

From the attached excel file, we have:

Estimated CoolTech's common stock value per share = $11.77

b. Judging on the basis of your finding in part a and the stock's offering price, should you buy the stock?

Stock's offering price = $12.50

Estimated CoolTech's common stock value per share = $11.77

Since the Stock's offering price of $12.50 is higher than the estimated CoolTech's common stock value per share of $11.77, you should NOT buy the stock because it is currently overvalued.

c. On further analysis, you find that the growth rate in FCF beyond 2019 will be 3% rather than 2%. What effect would this finding have on your responses in parts a and b?

Note: See part b of the attached excel file for the estimation of CoolTech's common stock value per share (in bold red color).

Stock's offering price = $12.50

From the attached excel file, we have:

Estimated CoolTech's common stock value per share = $14.41

Since the Stock's offering price of $12.50 is lower than the estimated CoolTech's common stock value per share of $14.41, you should buy the stock because it is currently undervalued.