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You are evaluating the potential purchase of a small business with no debt or preferred stock...


You are evaluating the potential purchase of a small business with no debt or preferred stock that is currently generating ​$41,700 of free cash flow​(FCF0​=​$41,700​).On the basis of a review of​ similar-risk investment​ opportunites, you must earn​ a(n) 20​% rate of return on the proposed purchase. Because you are relatively uncertain about future cash​ flows, you decide to estimate the​ firm's value using several possible assumptions about the growth rate of cash flows.

a. What is the​ firm's value if cash flows are expected to grow at an annual rate of​ 0% from now to​ infinity?

b. What is the​ firm's value if cash flows are expected to grow at a constant annual rate of 6​% from now to​ infinity?

c. What is the​ firm's value if cash flows are expected to grow at an annual rate of 11​% for the first 2​ years, followed by a constant annual rate of 6​% from year 3 to​ infinity?

Solutions

Expert Solution

Free Cash Flow is $ 41700 and Rate of Return is 20%

a. What is the​ firm's value if cash flows are expected to grow at an annual rate of​ 0% from now to​ infinity?

Answer: FCF / (Rate of Return%) = 41700/20% = $ 208500

b. What is the​ firm's value if cash flows are expected to grow at a constant annual rate of 6​% from now to​ infinity?

Answer: FCF / (Rate of Return% - Growth %) = 41700/(20%-6%) = $ 297857.14

c. What is the​ firm's value if cash flows are expected to grow at an annual rate of 11​% for the first 2​ years, followed by a constant annual rate of 6​% from year 3 to​ infinity?

Answer: Workings as below:  $ 344397.32

jeff jeffy answered 2 years ago
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