Question

Over the next three years, a firm is expected to earn economic profits of $60,000 in the first year, $50,000 in the second year, and $20,000 in the third year. After the end of the third year, the firm will go out of business. a. If the risk-adjusted discount rate is 6 percent for each of the next three years, the value of the firm is $________. The firm can be sold today for a price of $________. b. If the risk-adjusted discount rate is 11 percent for each of the next three years, the value of the firm is $________. The firm can be sold today for a price of $________.

Answer 1

Formula sheet

A	B	C	D	E	F	G	H
2
3		a)
4		Value of the firm today will be the present value of the expected future cash flows.
5		Cash Flow of the firm will be as follows:
6		Year	0	1	2	3
7		Cash Flow		60000	50000	20000
8
9		Calculation of value of the firm at discount rate of 6%:
10
11		Year	0	1	2	3
12		Cash Flow		=E7	=F7	=G7
13		MARR (i)	0.06
14		(P/F,i,n) for each year		=1/((1+$D13)^E11)	=1/((1+$D13)^F11)	=1/((1+$D13)^G11)
15		Present Value of cash flows = FCF*(P/F,i,n)		=E12*E14	=F12*F14	=G12*G14
16		Present value if future cash flows	=SUM(E15:G15)	=SUM(E15:G15)
17
18		Hence value of the firm at 6% discount rate is	=D16
19
20		The firm can be sold today at the value calculated above.
21
22		Hence firm can be sold today at the price of	=D18
23
24		b)
25
26		Calculation of value of the firm at discount rate of 11%:
27
28		Year	0	1	2	3
29		Cash Flow		=E7	=F7	=G7
30		MARR (i)	0.11
31		(P/F,i,n) for each year		=1/((1+$D30)^E28)	=1/((1+$D30)^F28)	=1/((1+$D30)^G28)
32		Present Value of cash flows = FCF*(P/F,i,n)		=E29*E31	=F29*F31	=G29*G31
33		Present value if future cash flows	=SUM(E32:G32)	=SUM(E32:G32)
34
35		Hence value of the firm at 11% discount rate is	=D33
36
37		The firm can be sold today at the value calculated above.
38
39		Hence firm can be sold today at the price of	=D35
40