1. Delta Software earned $10 million this year. Suppose the growth rate of Delta

Question

1. Delta Software earned $10 million this year. Suppose the growth rate of Delta's profits and the interest rate are both constant and Delta will be in business forever. Determine the value of Delta Software when a. The interest rate is 10 percent and profits grow by 4 percent per year. (5 points) b. The interest rate is 10 percent and profits grow by 0 percent per year. (5 points) c. The interest rate is 10 percent and profits decline by 4 percent per year. (5 points) d. The interest rate is 10 percent and profits grow by 12 percent per year. (This part of the question is tricky.) (5 points)

Explanation / Answer

a)

Delta Software’s Profit for this year = D0 = $10 Million

Profit Growth rate = g = 4% = 0.04

Interest rate = R = 10% = 0.10

So Delta Software’s Profit for next year = D1 = D0 x (1 + 0.04)

=> D1 = $ 10 Million x 1.04

=> D1 = $10.4 Million

According to the constant-growth model of valuation, also known as the Gordon Model,

The Value of the Delta Software = D1 / (R – g)

                                                                = $10.4 Million / (0.10 – 0.04)

                                                                = $10.4 Million / 0.06

                                                                = $173.34 Million

b)

Delta Software’s Profit for this year = D0 = $10 Million

Profit Growth rate = g = 0% = 0.00

Interest rate = R = 10% = 0.10

So Delta Software’s Profit for next year = D1 = D0 x (1 + 0.00)

=> D1 = $ 10 Million x 1.00

=> D1 = $10 Million

According to the constant-growth model of valuation, also known as the Gordon Model,

The Value of the Delta Software = D1 / (R – g)

                                                                = $10 Million / (0.10 – 0.00)

                                                                = $10 Million / 0.10

                                                                = $100 Million

c)                                                  

Delta Software’s Profit for this year = D0 = $10 Million

Profit Growth rate = g = -4% = -0.04

Interest rate = R = 10% = 0.10

So Delta Software’s Profit for next year = D1 = D0 x (1 - 0.04)

=> D1 = $ 10 Million x 0.96

=> D1 = $9.6 Million

According to the constant-growth model of valuation, also known as the Gordon Model,

The Value of the Delta Software = D1 / (R – g)

                                                                = $9.6 Million / (0.10 – (- 0.04))

                                                                = $9.6 Million / 0.14

                                                                = $68.571 Million

d)

Delta Software’s Profit for this year = D0 = $10 Million

Profit Growth rate = g = 12% = 0.12

Interest rate = R = 10% = 0.10

So Delta Software’s Profit for next year = D1 = D0 x (1 - 0.12)

=> D1 = $ 10 Million x 1.12

=> D1 = $11.2 Million

According to the constant-growth model of valuation, also known as the Gordon Model,

The Value of the Delta Software = D1 / (R – g)

                                                                = $11.2 Million / (0.10 – 0.12)

                                                                = $11.2 Million / - 0.02

                                                                = - $560 Million

Here the Value of the company is coming negative, which is unnatural.

This is because he Profit Growth rate is more than the Interest rate, which is unnatural.

You can’t value the Company using Terminal Value (Gordon Model) calculation.

You need to find other parameters of the Company such as Earning before Tax and Interest (EBIT) and use Exit Multiple method to calculate the Value of the Company.

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