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Shamrock, Inc. owns 25% of the common shares of Whispering Winds Corp. The other 75% of...

Shamrock, Inc. owns 25% of the common shares of Whispering Winds Corp. The other 75% of the shares are owned by the Sheffield family. Shamrock acquired the shares eight years ago through a financing transaction. Each year, Shamrock has received a dividend from Sheffield. Sheffield has been in business for 60 years and continues to have strong operations and cash flows. Shamrock must determine the fair value of this investment at its year end. Since there is no market on which the shares are traded, Shamrock must use a discounted cash flow model to determine fair value.

Shamrock management intends to hold the shares for 5 more years, at which time they will sell the shares to the Sheffield family under an existing agreement for $1 million. There is no uncertainty in this amount. Management expects to receive dividends of $81,000 for each of the five years, although there is a 20% chance that dividends could be $47,500 each year. The risk-free rate is 6% and the risk-adjusted rate is 8%.

Calculate the fair value of the investment in Sheffield using the traditional approach. (For calculation purposes, use 5 decimal places as displayed in the factor table provided. Round answers to 0 decimal places, e.g. 5,275.)

Calculate the fair value of the investment using the expected cash flow approach. (For calculation purposes, use 5 decimal places as displayed in the factor table provided. Round answers to 0 decimal places, e.g. 5,275.)

Solutions

Expert Solution

calculation of the fair value of the investment as per traditional approch

annual cash expected = $81000( PV factor of anuity 5 years , 8% )

= $ 81000* 3.9927100 = $ 323410

and at the end of 5 year sales proceed also received

= $ 10,00,000 ( PV factor for year 5 , 8% )

= $ 10,00,000 * .680583

=$ 680583

hence the fair value of investment = $ 323410 + $ 680583 = 1003993

2)calculation of the fair value of the investment as per expected cash flow  approch

The probability weighted annual cash flow is
$ 81000 * 80%   $ 64800 because 80% chance dividend of 81000 will be received
$ 47500 * 20% $ 9500 because 20% chance dividend of 47500 will be received
$ 74300

annual cash flow = $ 74300 ( ( PV factor of anuity 5 years , 6% )

= $ 74300 * 4.21236

=$ 312978

and at the end of 5 year sales proceed also received

= $ 10,00,000 ( PV factor for year 5 , 6% )

= $ 10,00,000 * 0.747258

=$ 747258

hence the fair value of investment = $ 312978 + $ 747258 = 1060236

in the cash flow approch we take risk free rate because cash flows are already adjusted for risk so we discounted with risk free rate

ekkarill92 answered 2 years ago
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