Question

Portage Bay Enterprises has $1 million in excess cash, no debt, and is expected to have free cash flow of $10 million next year.

Its FCF is then expected to grow at a rate of 3% per year forever.

If Portage Bay's equity cost of capital is 11% and it has 5 million shares outstanding, what should be the price of Portage Bay stock?

Why is the answer = 10/(0.11-0.03), which is ($125 + $1)/5 = 25.2

and NOT = (10*1.03)/(0.11-0.03), which is ($128.75 +$1)/5 = 25.95?

They said that the FCFs is expected to grow "it then expected to grow", i.e. - AFTER next year. We should include this growth ....

Answer 1

The formula for terminal growth in FCF is FCF *(1+g)/(k-g) where FCF is the terminal years cash flows and g is the growth in cash flows.

Terminal Value in Year 1 = 10*(1+3%) /(0.11 - 0.03) = $ 128.75

Enterprise Value (EV) of the firm =( PV of $ 10 M cash flows + PV of terminal value) = 10/(1+0.11) + 128.75/(1+0.11) = $ 125

So MV of Equity = EV + Cash = 125 + 1= $ 126

Price per stock = 126/ 5 = $ 25.2

Note : The formula FCF*(1+g)/(k-g) is correct. However, the reason the answer is $ 125 is because, the terminal cash flows and FCF occur at the end of 1st year and these cash flows have to be discounted at the cost of capital to the current year yielding a value of $ 25.2 per share