The head of the accounting department at a major software manufacturer has asked

Question

The head of the accounting department at a major software manufacturer has asked you to put together a pro forma statement of the company's value under several possible growth scenarios and the assumption that the company's many divisions will remain a single entity forever. The manager is concerned that, despite the fact that the firm's competitors are comparatively small, collectively thei annual revenue growth has exceeded 50 percent over each of the last five years. She has requested that the value projections be based on the firm's current profits of $3.2 billion (which have yet to be paid out to stockholders) and the average interest rate over the past 20 years (6 percent) in each of the following profit growth scenarios: a. Profits grow at an annual rate of 9 percent. (This one is tricky. Click to select) nstructions: Enter your responses rounded to two decimal places b. Profits grow at an annual rate of 2 percent billion c. Profits grow at an annual rate of O percent. billion d. Profits decline at an annual rate of 4 percent. billion

Explanation / Answer

In this case, we will use gordan growth model to estimate the value of company.

As per dividend discount model, value of company is CF0*(1+g)/(r-g), where CF0 is is cash flow in current year, r is interest rate, and g is growth rate.and should be less than interest rate

In this case, CF0 = $3.2 billion

r = 6%

a.) Profits are growing at 9%

In this case, g is more than interest rate i.e. 9%>6%

So this scenario is not possible.

b.) In this case, growth is 2%

g = 2%

Putting this in equation of gordan growth model

Value = 3.2*(1+0.02)/(0.06-0.02) = $81.60 billion

c.) In this case, growth is 0%

g = 0%

If g is 0, then value = CF0/r

putitng now values in equation,

Value = 3.2/0.06 = $53.33 billion

d.) In this case, growth is -4%, as profits are declining

g = -4%

Putting this in equation of gordan growth model

Value = 3.2*(1-0.04)/(0.06+0.04) = $30.72 billion

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