Lamps Galore Inc. manufactures table lamps and earns an after-tax return on capi
ID: 2788711 • Letter: L
Question
Lamps Galore Inc. manufactures table lamps and earns an after-tax return on capital of 15% on its current capital invested (which is $100 million). You expect the firm to reinvest 80% of its after-tax operating income back into the business for the next four years and 30% thereafter (the stable growth period). The cost of capital for the firm is 9%.
A) Estimate the terminal value for the firm (at the end of the fourth year).
B). If you expect the after-tax return on capital to drop to 9% after the fourth year, what would your estimate of terminal value be?
Explanation / Answer
High growth rate = Reinvestment rate * Return on capital
High growth rate =80% * 15% = 12%
Stable growth rate =30% * 15% = 4.5%
EBIT in the 4th year = 15%*100*(1+12%)4 = 23.60
Terminal value = 23.60*(1+4.5%) * (1-30%) / (9% - 4.5%) = 383.68 million
B)
High growth rate = Reinvestment rate * Return on capital
High growth rate =80% * 9% = 7.2%
Stable growth rate =30% * 9% = 2.7%
EBIT in the 4th year = 9%*100*(1+7.2%)4 = 11.89
Terminal value = 11.89*(1+2.7%) * (1-30%) / (9% - 2.7%) = 135.63 million
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