Suppose you started a new company, which is expected to generate a Return on Invested Capital ROIC of 15% per year. The company is all-equity financed and the book value of the Invested Capital (equity) equals $5 million. The cost of capital for the firm is 10% and you expect the firm to grow at a constant rate of 5% forever with a corresponding reinvestment rate of 33.33%. With this information, please answer the following three questions.

(i)  What is the intrinsic value of the company and what is its value to book ratio? Show your calculations.

(ii)  What drives the difference between the book value and the intrinsic value of the firm, and what are the levers the firm can use to enhance its value? Clearly motivate your answer.

(iii)  Suppose you are considering two strategies to increase the value of the firm. The first strategy is a fast expansion strategy, which doubles the firm's growth rate to 10% at a ROIC of 15%, but increases the firm's risk and results in a cost of capital of 12%. The second strategy is a risk reduction strategy, which results in a cost of capital of 7% and a lower growth rate of 3% at a ROIC of 15%. Using the DCF-framework, determine the value of the firm under each of these strategies. Is the firm better off with a focus on fast growth or on risk reduction? Motivate your approach and show all your calculations.

Answer rating: 100% (QA)

SOLUTION i To calculate the intrinsic value of the company we can use the Gordon Growth Model which is Intrinsic value ROIC g r g Invested Capital whe... View the full answer