Common stock values - All growth models Personal Finance Problem. You are evalua

Question

Common stock values - All growth models Personal Finance Problem. You are evaluating the potential purchase of a small business currently generating $ 41, 500 of after-tax cash flow (D_0 = $ 41, 500). On the basis of a review of similar-risk investment opportunities, you must earn a rate of return of 16 % on the proposed purchase. Because you are relatively uncertain about future cash flows, you decide to estimate the firm's value using two possible assumptions about the growth rate of cash flows. What is the firm's value if cash flows are expected to grow at an annual rate of 0% from now to infinity? What is the firm's value if cash flows are expected to grow at an annual rate of 7% from now to infinity? What is the firm's value if cash flows are expected to grow at an annual rate of 12% for the first two years, followed by a constant annual rate of 7% from year 3 to infinity? The firm's value if cash flows are expected to grow at an annual rate of 0% from now to infinity in $ .(Round to the nearest dollar.) The firm's value if cash flows are expected to grow at an annual rate of 7% from now to infinity in $ .(Round to the nearest dollar.) The firm's value if cash flows are expected to grow at an annual rate of 12% for the first two years, followed by a constant annual rate of 7% from year 3 to infinity is $ .(Round to the nearest dollar.)

Explanation / Answer

a. Firm value = $41,500 * (1 + 0%) / (16% - 0%)

= $259,375.00

b. Firm value = $41,500 * (1 + 7%) / (16% - 7%)

= $493,388.89

c. Firm value = $41,500 * (1 + 12%) / (1 + 16%) + $41,500 * (1 + 12%)2 / (1 + 16%)2 + $41,500 * (1 + 12%)2 / (1 + 16%)2 * (1 + 7%) / (16% - 7%)

= $538,704.98

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