1.You are an analyst evaluating Up-and-Coming Airlines Inc., a very hot potentia

Question

1.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?

Explanation / Answer

Up-And-Coming Airlines Details Amt $ Purchase Price          60,000,000 Yearly after Tax cash Flow            1,000,000 Yearly after Tax cash Flow not invested Further                500,000 PV of univested cash flow @10% discount            5,000,000 Yearly after Tax cash Flow invested Further                500,000 Assume the return of invested amt is k Yearly return on invested amt 500000k PV of yearly return of invested amt @10% =500,000k/0.10 The PV of return of invested amount should be $55,000,000 to justify investment Or 500,000*k/0.10=55,000,000 or , 500,000k= 55,00,000 k= 11 K=1100% so yearly return =5,500,000 Therefore the required return from Up & Coming's new investments need to be 1100% to justify 60 M price

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