Question

Ms. Brown, the owner of Southern Comfort Inc., has approached you with an offer to sell you her company for paid her a dividend of $10 ilion last year. She provided you with the following expected cash flow analysis (see the table below), and your assistant confirmed that the projections are reasonable. T3 $17 $68 Year TO T1 T2 ValueS12 If Ms Brown sells to you, what is her realized annual rate of return on her original A. investment? The risk free rate is 5%. INI). If you negotiate and are able to buy Southern Comfort for $75 million, what is your expected rate of return on this investment? Should you buy Southern Comfort? (answer YES or C.

Answer 1

	A	Original Investment	$60	million
	B	Dividend received in year 1	$10	million
	C	Sales value in year 2	$80	million
	D=B+C	Total amount received	$90	million
	E=D-A	Realized return in two years	$30	million
	F=E/2	Average annual return	$15	million
	G=F/A	Realized annual rate of return	0.25
		Realized annual rate of return	25.00%
		Present Value (PV) of Cash Flow:
		(Cash Flow)/((1+i)^N)
		i=Discount Rate=Risk free rate=5%	0.05
		N=Year of Cash Flow
	N	Year	1	2	3
	A	Dividend	$12	$15	$17
	B	Firm value			$68
	C=A+B	Total cash in flow($million)	$12	$15	$85	SUM
	D=C/(1.05^N)	Present Value of Cash in flow	11.42857	13.60544	73.4262	98.46021
		Present Value of Cash in flow	$98.46	million
		Net Present Value (NPV)	$18.46	million	(98.46-80)
		NPV is positive
		YES, We should buy for $80 million
		If we buy for 75 million,
		Total realized amount in 3 years	$112	million	(12+15+17+68)
		Total realized return in 3 years	$37	million	(112-75)
		Average annual return	$12.33	million	(37/3)
		Annual rate of return	0.16	(12.33/75)
		Annual rate of return	16.44%