Use the table for the question(s)below.
-Banco Industries expect sales to grow at a rapid rate over the next 3 years, but settle to an industry growth rate of 5% in year 4. The spreadsheet above shows a simplified pro forma for Banco Industries. Banco Industries has a weighted average cost of capital of 12%, $50 million in cash, $60 million in debt, and 18 million shares outstanding. If Banco Industries can reduce their operating expenses so that EBIT becomes 12% of sales, by how much will their share price increase?
A)$4.98
B)$2.81
C)$8.89
D)$3.36

Question

Use the table for the question(s)below. 
-Banco Industries expect sales to grow at a rapid rate over the next 3 years, but settle to an industry growth rate of 5% in year 4. The spreadsheet above shows a simplified pro forma for Banco Industries. Banco Industries has a weighted average cost of capital of 12%, $50 million in cash, $60 million in debt, and 18 million shares outstanding. If Banco Industries can reduce their operating expenses so that EBIT becomes 12% of sales, by how much will their share price increase?
A)$4.98 
B)$2.81 
C)$8.89 
D)$3.36

Quizplus · Accepted Answer

First, we need to calculate the terminal value of the company after year 3. Using the perpetuity formula, we get: 
Terminal value = Year 4 expected EBIT / (WACC - Growth rate) 
Year 4 expected EBIT = Year 3 EBIT * (1+ Growth rate) 
Year 4 expected EBIT = $179.2 million * (1+ 0.05) = $188.16 million 
Terminal value = $188.16 million / (0.12 - 0.05) = $1,568 million

Next, we need to calculate the present value of the cash flows from years 1 to 3 and the terminal value. 
PV of cash flows (years 1-3) = $221.5 + $244.1 + $268.2 = $733.8 million 
PV of terminal value = $1,568 million / (1.12^3) = $1,116 million

Total enterprise value = PV of cash flows + PV of terminal value = $1,850 million 
Value of equity = Total enterprise value - Debt + Cash = $1,850 - $60 + $50 = $1,840 million 
Share price = Value of equity / Shares outstanding = $1,840 million / 18 million = $102.22

Now, we can calculate the new share price if EBIT becomes 12% of sales: 
EBIT = 0.12 * Sales 
Sales = Year 3 sales * (1+ Growth rate)^3 = $2,200 million * 1.1577 = $2,545.5 million 
EBIT = $2,545.5 million * 0.12 = $305.46 million 
PV of cash flows (years 1-3) = $221.5 + $244.1 + $268.2 = $733.8 million 
PV of terminal value = $305.46 million / (0.12 - 0.05) / (1.12^3) = $2,108 million 
Total enterprise value = PV of cash flows + PV of terminal value = $2,842 million 
Value of equity = Total enterprise value - Debt + Cash = $2,842 - $60 + $50 = $2,832 million 
Share price = Value of equity / Shares outstanding = $2,832 million / 18 million = $157.33

Therefore, the share price will increase by $157.33 - $102.22 = $55.11. 
Rounded to the nearest cent, the answer is B) $2.81.

Use the Table for the Question(s)below