Question

You are valuing a firm with a “pro forma” (i.e., with your forward projection of what the cash flows will be). The firm just had cash flows of $1,000,000 today. This year, it will be growing by a rate of 20% per annum. That is, at the end of year 1, the firm will have a cash flow of $1.2 million. In each of the following years, the difference between the growth rate and the inflation rate of 2% will (forever) halve. Thus, from year 1 to year 2, the growth rate will be 2% + (20% – 2%)/2 = 11%, so the next cash flow will be $1,200 · 1.11 = $1,332 at the end of year 2. The following year, the growth rate will be 2% + (11% – 2%)/2 = 6.5%, and the cash flow will be $1,419 at the end of year 3. The growth will be less every year, but it will never reach the inflation rate of 2% perfectly. Next, assume that the appropriate discount rate for the firm this risky is a constant 12% per year. It is not time-varying. (The discount rate on the $1.2 million cash flow is 12%. The total discount rate for the $1,332 cash flow in year 2 is thus 25.4%, and so on.) What do you believe the value of this firm to be? ? (Hint: It is common in pro formas to project forward for a given number of years, say, 5 to 10 years, and then to assume that the firm will be sold for a terminal value, assuming that it has steady growth.)

Answer 1