The head of the accounting department at a major software manufacturer has asked
ID: 1255788 • Letter: T
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 their 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 $4.9 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:
1. Profits grow at an annual rate of 8 percent.
a. The growth rate is not possible
b. The firm's value is infinate
c. The firm will have to shut down at this growth rate
d. The firm's value is zero
2. Profits grow at an annual rate of 4 percent
___billion
3. Profits grow at an annual rate of 0 percent.
___billion
4. Profits decline at an annual rate of 2 percent.
___billion
Explanation / Answer
Value = Present value of all future cash inflows = Present value of future net income
= Current profits / (Interest rate - Growth rate) = $4.9 billion / (0.06 - g) [where g: Growth rate of profits]
(1) Option (c)
If growth rate is 8%, denominator becomes negative. This makes firm's value go down, so the firm will shut down.
(2) g = 4%
Value = $4.9 billion / (0.06 - 0.04) = $4.9 billion / 0.02 = $245 billion
(3) g = 0%
Value = $4.9 billion / (0.06 - 0) = $4.9 billion / 0.06 = $81.67 billion
(4) g = - 2%
Value = $4.9 billion / (0.06 + 0.02) = $4.9 billion / 0.08 = $61.25 billion
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