A "momentum-driven" investment consultant is pitching Lumina Cloud Systems (LCS) to your client. The consultant claims LCS is a bargain because its…

CA Final · Advanced Financial Management · PYQS · May 2026
A "momentum-driven" investment consultant is pitching Lumina Cloud Systems (LCS) to your client. The consultant claims LCS is a bargain because its Cash Flow from Operations (CFO), when capitalized at the prime lending rate of 9%, yields a value of 425 per share. LCS currently trades at 240 per share. You are required to perform a Two-Stage FCFE Valuation to verify these claims. Financial Data & Assumptions: Net Income (Base Year):180 Crores.High-Growth Stage (Years 1-2): Net Income will grow by 25% annually.Net Investment in Operating Assets: This is projected to be 240 Crores in Year 1 and 280 Crores in Year 2. (Note: This represents capital expenditure less depreciation plus the increase in working capital).Debt Policy: The Company finances 30% of its net investment in operating assets through new debt.Cost of Equity: The risk-free rate is 6%, the company's Beta is 1.20 and the Equity Risk Premium (ERP) is 5%.Stable Stage (Year 3 onwards): Net investment in operating assets will drop to 20% of Net Income each year.Outstanding Shares: 60 Crores. Present Value Factor: 1 st Year 2 nd Year 3 rd Year 12% 0.893 0.797 0.7118 Requirements: (i) Calculate the total Present Value of the FCFE for the high-growth period (Stage 1). (ii) If the current market price of 240.00 is considered "fair" by the market, calculate the implied sustainable growth rate for the terminal stage (Year 3 onwards).

Suggested Answer and Working Notes:

Working Notes: (1) Computation of Cost of Equity (ke) Using the CAPM formula ke = 6% + 1.20% (5%) = 12% (2) Calculation of FCFE for High-Growth Period (Stage 1) Since 30% of net investment is debt-financed, the equity-funded portion is 70% Particulars (in Crores) Year 1 Year 2 Year 3 onwards Net Income 180 x 1.25 = 225 225 x 1.25 = 281.25 281.25 Less: Net Investment (Equity portion 70%) 240 x 0.70 = 168.00 280 X 0.70 = 196.00 281.25 x 0.20 x 0.70 = 39.375 FCFE 57.00 85.25 241.875 PV Factor at 12% 0.893 0.797 PV of FCFE 50.90 67.94 (i) Total PV of Stage 1 Cash Flows = 50.90 Crores +67.94 Crores = 118.84 Crores (ii) Implied Sustainable Growth Rate (g): To find the growth rate (g) implied by the market price of 240, we solve for the Terminal Value (TV2) Total Market Capitalization:240 per share x 60 crore shares = 14,400 CroresPV of Terminal Value (at Year 0):14,400 Crores - 118.84 Crores = 14,281.16 CroresTerminal Value at end of Year 2 = 14,281.16 x (1.12)² = 17,914.29 Crores FCFE for Year 3 (FCFE_3) Gordon Growth Model: 17,914.29 = 241.875 x (1+g)/ (0.12 – g) Solving for (g): 2,149.7148 - 17,914.29g = 241.875 + 241.875g g = 0.1051 i.e. 10.51% The market is pricing in an implied sustainable growth rate of 10.51%. Alternative Presentation (i) Cash flow from operation per share = 425 x 0.09 = 38.25 Since number of outstanding shares is 60 crore Total Cash from Operation shall be 2295Crore (₹ 38.25 x 60 crore) ke = 6% + 1.20 x 5% = 12% ₹ Crore Particulars Year 1 Year 2 Net Income 225.00 281.25 Net Investment through Equity 168.00 196.00 57.00 85.25 PVF@12% 0.893 0.797 PV 50.901 67.944 Total Present Value of FCFE for the High Growth Period is 118.845 Crore. (ii) Now let g be the implied sustainable growth rate then FCFE in Year 3 and onward shall be: = 281.25 x (1+g) – [281.25(1+g) x 0.20 x 0.70] = 281.25 + 281.25g – 39.375 – 39.375g = 241.875g + 241.875 If 240is considered as Fair Value as Fair Value = 240 x 60 crore = 14400 crore Accordingly, 118.845 + 241.875+241.875g x 0.797 = 14400 0.12-g On solving the equation g = 0.1050 i.e., 10.50%

Topics: Business Valuation

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