Question

Your company manufactures widgets. The fixed cost incurred (independent of the number of widgets produced) each year is $80,000. The variable cost per widget is $0.25. The sale price of each widget is $1.00. The price and the costs are expected to remain unchanged over time. In year 1, the company expects to sell 100,000 widgets. It expects its sales to increase at the rate of 4% a year forever. The discount rate is 10%. Ignore taxes. What is the value of this company?

Answer 1

Sales and variable costs are linked. So it will increase at 4%. But fixed costs remains same. So separate present values of contribution and fixed costs shall be calculated. Difference of contribution present values over fixed cost present value will be present. value of firm

.      
Sales(100000*1)=   100000  
less : variable costs(0.25*100000)   -25000  
Contribution    75000  
      
      
So growth rate=   4%  
Discount rate=   10%  
      
Present value of contribution = Contribution/(Discount rate - growth rate)      
75000/(0.10-0.04)= $1250000  
      
Fixed costs =    $80,000  
Present value of fixed costs = 80000/(0.10-0)=   $800,000  
      
Value of this company = PV of contribution - PV of fixed costs      
1250000 -$800,000  
$450,000     

So value of this company is $450000