Question

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?

Use P0 = (EPS1 / r) +PVGO formula

Answer 1

Details of Up-and-Coming airlines Inc Particulars Estimated annual earnings from existing assets Value of Investment oppurtunity that gives earnings indefinitely(50% of annula earnings. 1x50%) Appropriate discount rate forthe above mentioned cash flows Purchase price 1.00 0.50 10% 60.00 Any ratinoal investor would willing to invest/pay the amount which is equivalent to discounted value of future benefits associated with such investment/pay Accordingly let's see whether proposed 60mn purchase prcie is excesess or short of it's presentvalue of benefits from purchasing the compant And Present value of future benefits is nothing but all cash flows (1 mn &0.50' x%) associated with above investment (60mn)discounted at risk rate (10%) Let's say x% IS the required rate of return from new investment( out of 50% earnings) To jutify the 60mn price, discounted future benefits shall equal to 60mn s list out the future (For one year ] benefi Expected dividned at the end of one year from now Half of the earnings are invested i.e half of the eanings are declared as dividend0.5 mn Growth of the company (g%) Discount ratel Ke 1 and 50% earnings from new investment will also be distribued as dividend . .0.5 mn"X%"50% -10% Now to justify 60mn, 60mn- Expected dividend/ke-g 60 mn (0.5 mn + 0.5mn"X%+50%)/( 10%-50% "X%) somna 0.5mn+0.25mm"1%)/( 10%-0.51%) 50mn( 10%-0.5x%)= 0.5mn+0.25mm" 6mn-30mr'x%-0.5mn+0.25mn°1% 30mn"r%+0.25mn"X96-6mn-0.5mn 30.25mn"0%-5.5mm x%-5.5mn/30.25 x-0.18181818 x 18.1896 Accordingly to justify the 60mn price, required rate of return on new investment is 18.18%