Question

We wish to estimate the value of Portal Inc. under alternative assumptions about the

firm’s performance.

           

Determine Enterprise Value and MV of Equity

Using the discounted cash flow (DCF) approach to valuation and the following

assumptions, provide an estimate of Portal’s value.

This year sales are expected to be $750 million. They are expected to grow at a rate of 5 percent per year for the next four years and then at 3 percent per year forever.

The pre-tax operating margin currently at 15 percent will grow at a rate of 1 percent every year for four years and then stabilize at 20 percent forever

The working capital requirement to sales ratio will remain at is current level of 18 percent forever

Capital expenditure will be $50 million this year and will grow at the same rate as the sales

Annual depreciation expense for the current year will be $50 million and then grow at the same rate as the capital expenditure

Portal Inc. has $500 million of debt outstanding. It can borrow at 6 percent

Portal’s income tax rate is 40 percent

Portal’s beta is 1.05. The risk free rate and the market risk premium are 5 percent

The debt to total capital ratio of Portal, at market value is 50 percent.

Answer 1

Growth rate of Sales : 5% for 4 years and 3% there on

Before Tax Operating margin is provided in the question. So we can calculate Operating profit

Operating Profit = Revenue * Operating Margin

Similiarly Working Capital / Sales ratio is given. Using this, we can calculate the Working capital requirements

Working Capital = Working Capital / Sales * Sales

Capital Expenditure growth rate = Depriciation growth rate = revenue growth rate

Since we have Pre tax Profit calculated above, we can calculated net profit using that.

Free Cash Flow to Firm = Net Income + Depriciation - Capital Expenditures - Change in working capital

Using this formula we can calculate FCFF for all the years. Also, it is given in the question that growth rate is 3% forever, we can use Gordon Growth formula to calcluate value at the end of 4th year, which then can be discounted to find the present value.

We also need WACC as a discount rate to find present value. For that we need to find Cost of Equity:

Using CAPM : Ke = Rf + beta*(premium)

After tax Kd = Kd *(1-tax)

Also weights of debt and equity in the capital structure are equal.

Using all these, we can find WACC.

Discount the Free cash flows with wacc and find tjhe firm value, which is equal to Enterprise Value in our case since.

Also , MV of equity = EV - Debt