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 1 year ago

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