You are evaluating the potential purchase of a small business currently generati
ID: 2709202 • Letter: Y
Question
You are evaluating the potential purchase of a small business currently generating $42,500 after-tax cash flow (Do=$42,500). On the basis of a review of similar-risk investment opportunities, you must earn an 18% rate of return on the proposed purchase. Because you are relatively uncertain about future cash flows, you decide to estimate the firms value using several possible assumptions about the growth of the cash flows.
a. What is the firm's value if cash flows are expected to grow at an annual rate of 0% from now to infinity?
b. What is the firm's value if cash flows are expected to grow at a constant annual rate of 7% from now to infinity?
c. What is the firm's value if cash flows are expected to grow at an annual rate of 12% for the first 2 years, followed by a constant annual rate of 7% from year 3 to infinity?
Explanation / Answer
This is valued as a perpetuity: Price p0=(cf0/r)
p0 = 42,500 / 0.18 = $236,111.11
b) use Gordon growth model: Price at t=0
"P0" = D1 / (r - g),
where D1 = D0(1 +g)
D1 = 42,500(1.07) = 45,475
P = 45,475 / ( 0.18 - 0.07)
= 45,475 / 0.11
= $413,409.09
c) D1 = 42,500*1.12 = 47,600
D2 = 47,600 * 1.12 = 53,312
D3 = 53,312 * 1.07 = 57,043.84
Use Gordon growth model to determine the "terminal value" IN year 2 "P2". [Since price is forwarding looking, you know the Price IN year 2, based on the year 3 dividend. Discount this price TWO years, since it is the price IN year 2. A common mistake is to discount this 3 years.]
P2 = D3 / ( r - g)
P2 = 57,043.84 / (0.18 - 0.07)
= $518,580.36
P0 is the sum of the discounted cash flows. Again, be sure to discount P2 by only 2 years...
P0 = (47,600 / 1.18) + (53,312 / 1.18^2) + (518,580.36 / 1.18^2)...reduce...
= (47,600 / 1.18) + (571,892.36 / 1.18^2)
= 40,338.98 + 410,724.19
= $451,063.17
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