Mexican Motor's market cap is 200 billion pesos. Next year's cash flow is 8.6 billion pesos. A...

Question:

Mexican Motor's market cap is 200 billion pesos. Next year's cash flow is 8.6 billion pesos. A security analyst is forecasting that free cash flow will grow by 7.60% per year for the next five years.

Requirements:

(a) Assume that the 7.60 growth rate is expected to continue forever. What rate of return are investors expecting?

(b) Mexican Motors has generally earned about 10% on book equity (ROE= 10%) and reinvested 50% of earnings. The remaining 50% of earnings have gone to free cash flow. Suppose the company maintains the same ROE and investment rate in the long run. What will be the growth rate of earnings?

(c) What would be the rate of return?

Required return:

The return of a stock is defined by the concept of the present value of a perpetuity. The rate at which all the future cash flows is discounted to get the value of the stock is the required return from the stock.

Answer and Explanation:

Question a)

Expected return from the stock
= Next cash flow / Market cap + Growth rate
= 8.6 / 200 + 0.076
= 0.119
= 11.90%

Question b)

Growth rate = Retention ratio x Return on Equity

Here,

Retention ratio = (100 - Payout ratio) = 50%

Return on equity = 10%

So,

Growth rate = 5%

Now,

Expected return from the stock
= 8.6 / 200 + 0.05
= 9.30%


Learn more about this topic:

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The Dividend Growth Model

from Finance 101: Principles of Finance

Chapter 14 / Lesson 3
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