Question

The head of the accounting department at a major software manufacturer has asked you to put together a pro forma statement of the company's value under several possible growth scenarios and the assumption that the company’s many divisions will remain a single entity forever. The manager is concerned that, despite the fact that the firm’s competitors are comparatively small, collectively their annual revenue growth has exceeded 50 percent over each of the last five years. She has requested that the value projections be based on the firm’s current profits of $5.2 billion (which have yet to be paid out to stockholders) and the average interest rate over the past 20 years (6 percent) in each of the following profit growth scenarios:

a. Profits grow at an annual rate of 7 percent. (This one is tricky.)


Instructions: Enter your responses rounded to two decimal places.

b. Profits grow at an annual rate of 3 percent.

________________

c. Profits grow at an annual rate of 0 percent.

________________

d. Profits decline at an annual rate of 5 percent.

________________

Answer 1

Answer:-

=> (A) here, the profit is growing (7%) faster than interest rate (6%), so the value of firm would be infinite.

=> (B) now we use following formula to find value of firm by assuming growth rate is greater than interest rate

Value of firm = π (1+i) / (i-g)

Value of firm = $5.2(1.06) / (0.6-0.03)

= 5.512/0.03

= $183.73

=> (C)

Value of firm = $5.2(1.06)/0.06-0

= $5.512/0.06

= $91.87

=> (D)

Value of firm = $5.2 ( 1.06) / (0.06-(-0.05)

= $5.512/0.11

= $50.11