Question

Problem 1: You are the potential purchase of a small financial consulting firm currently eating $45,000 of after ta sh flow. On the basis of reww of marrisk investment opportunities, you must earn a rate of return of on the proposed purchase. Because you are relatively uncertain about future cash flows, you decide to estimate the firm's value using assumptions about the growth of cash flows (ie, similar to the growth of dividends. Required: What is the firm's value cash flows are expected to grow at an annual rate of Oxfrom now to infinity? Required: What is the firm's value if cash flows are expected to grow at a constant rate from now to Infinity assuming the business has a 20% return on equity and plans to retain 25% of their earnings for investments in the form? Required: What is the firm's value assuming cash flows are expected to grow at an annual rate of 10% for the first two years of the initial growth period, followed by a constant annual rate of from year to infinity? Required: According to your calculations, should you buy the firm if the current market value is $220.000? Duplain.

Answer 1

After-tax cash flow of consulting firm = $45,000

Rate of Return = 20%

Part-1)

Firm’s value if cash flows are expected to grow at an annual rate of 0% from now to infinity = After Tax Cash Flows of the Consulting Firm /Rate of return

= 45,000/0.2

= $225,000

.

Part-2)

Growth rate of the firm = Return on Equity * (1-Retention Ratio)

= 20%*(1-0.25)

= 20%*0.75

= 15%

Firm’s value if cash flows are expected to grow at a constant rate of from now to infinity assuming growth rate calculate above i.e 15% = After Tax Cash Flows of the Consulting Firm /(Rate of return -Growth Rate)

= 45,000/(0.20-0.15)

= 45,000/0.05

= $900,000.

.

Part-3)

Firm’s Value if cash flows are expected to grow at an annual rate of 10% for the first two years of the initial growth period , followed by a constant annual rate of 5% from year-3 to infinity

Terminal Value of the firm at the end of 2^nd year = Year -3 After Tax Cash Flows of the Consulting Firm /(Rate of return -Growth Rate)

= 57,172.50/(0.20-0.05)

= = 57,172.50/0.15

= 381,150

.

Firm’s Value = Present value of cash flows for the first two years + Present Value of Terminal Value of the firm at the end of 2^nd year

= [ 49,500/1.20^1 + 54,450/1.20^2] + 381,150/1.20^2

= [41,250 + 37812.50] + 264,687.50

= 79,062.50 + 264,687.50

= $343,750