The table below shows the projected free cash flows of an acquisition target. Th

Question

The table below shows the projected free cash flows of an acquisition target. The potential acquirer wants to estimate its maximum acquisition price at an 8% discount rate and a terminal value in year 5 based on the perpetual growth equation with a 4% perpetual growth rate Year 1 2 3 4 5 Free CFs -600 -300 0 200 700 a. Estimate the target’s maximum acquisition price (2 points) b. Estimate the target’s maximum acquisition price when the discount rate is 7% and the perpetual growth rate is 5%. (2 points) c. Consider your answers to parts a) and b) of this question, what is the percentage change in the maximum acquisition price when the discount rate is reduced on percentage point and the perpetual growth rate is increased on percentage point? (2 points)

Explanation / Answer

a) Maximum acquisition price FOR DISCOUNT RATE OF 8% AND PERPETUAL GROWTH RATE OF 4% 1 2 3 4 5 Free cash flows -600 -300 0 200 700 Value at the end of the fifth year    based on perpetual growth rate of 4% 18200 -600 -300 0 200 18900 PVIF at 8% 0.925926 0.85734 0.793832 0.73503 0.6805832 PV at 8% -556 -257 0 147 12863.0224 Maximum acquisition price 12197 b) Maximum acquisition price FOR DISCOUNT RATE OF 7% AND PERPETUAL GROWTH RATE OF 5% 1 2 3 4 5 Free cash flows -600 -300 0 200 700 Value at the end of the fifth year    based on perpetual growth rate of 4% 36750 -600 -300 0 200 37450 PVIF at 7% 0.934579 0.87344 0.816298 0.7629 0.71299 PV at 7% -561 -262 0 153 26701 Maximum acquisition price 26031 c) Percentage change in maximum acquisition price = [(26031-12197)*100]/12197= 113.42%

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