You are an analyst evaluating Up-and-Coming Airlines Inc., a very hot potential
ID: 2733091 • Letter: Y
Question
You are an analyst evaluating Up-and-Coming Airlines Inc., a very hot potential acquisition candidate your company is considering. Up-and-Coming currently has no debt and you estimate that it should be able to generate $1 million a year from its existing assets (after tax cash flow). Furthermore, it has the opportunity to invest one-half of its earnings indefinitely. You estimate that because of better management, your company should be able to improve the rate of return that Up-and Coming can earn on its new investment opportunities. The appropriate discount rate for Up-and-Coming’s cash flows is 10%. Up-and-Coming can be purchased for $60 million and management asks you what you think. What rate of return would Up-and-Coming have to earn on its new investments to justify such a price?
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Explanation / Answer
1. Calculation of current value of Up and Coming Airlines Inc.,:
After tax profit = $1million
Discount rate = 10%
Current value =$1million/10%
= $10 million.
2.Calculation of Rate of return :
Original value = $60 million(Price can be for purchasing Up and coming)
Rate of return should be earned = Orignal price - Current value/Current value
= $60-$10/$10*100
= 500%
The rate of return should be earned by the company to earn on its new investments to justify such a price.Even though it's not that much good to pay $60 million as purchase price since it was not easy to earn 500% rate of return And chances of possibility was also very low.so it is advised that not to buy this company.
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