The head of the accounting department at a major software manufacturer has asked
ID: 2418614 • 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 $3 billion (which have yet to be paid out to stockholders) and the average interest rate over the past 20 years (9 percent) in each of the following profit growth scenarios:
a. Profits grow at an annual rate of 11 percent. (This one is tricky.)
(select one )---This growth rate is not possible or The firm will have to shut down at this growth rate or The firm's value is infinite or The firm's value is zero
Instructions: Round your responses to 2 decimal places.
b. Profits grow at an annual rate of 4 percent.
billion
c. Profits grow at an annual rate of 0 percent.
billion
d. Profits decline at an annual rate of 3 percent.
billion
Please round to correct decimals and make answers clear and complete.
Explanation / Answer
a. The firm's value is infinite because the firm's profit is growing at a higher rate (11%) than the average interest rate (9%). The formula for valuation is = firm's current profit or free cash flow/cost of capital - growth rate.
cost of capital = interest rate = 9%. growth rate = 11%. Thus firm's value = $3 billion/(9% - 11%) = infinite.
b. cost of capital = interest rate = 9%. growth rate = 4%. Thus firm's value = $3 billion/(0.09 - 0.04) = 3/0.05 = $60 billion.
c. cost of capital = interest rate = 9%. growth rate = 0%. firm's value = $3 billion/0.09-0 = 3/0.09 = $33.33 billion
d. cost of capital = interest rate = 9%. growth rate = -3%. firm's value = $3 billion/(0.09 - [-0.03]) = 3/0.12 = $25 billion.
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