Question

(Explain each step in depth and show your logic. Show formulas and the reasons for doing what your doing)

You are an analyst evaluating Up-and-Coming Airlines Inc., a very hot potential acquisition candidate your company is considering. Up-and-Coming currently has no debt and you estimate that it should be able to generate $1 million a year from its existing assets (after tax cash flow). Furthermore, it has the opportunity to invest one-half of its earnings indefinitely. You estimate that because of better management, your company should be able to improve the rate of return that Up-and Coming can earn on its new investment opportunities. The appropriate discount rate for Up-and-Coming’s cash flows is 10%. Up-and-Coming can be purchased for $60 million and management asks you what you think. What rate of return would Up-and-Coming have to earn on its new investments to justify such a price?

Answer 1

Up-And-Coming Airlines
Details	Amt $
Purchase Price	60,000,000
Yearly after Tax cash Flow	1,000,000
Yearly after Tax cash Flow not invested Further	500,000
PV of univested cash flow @10% discount	5,000,000
Yearly after Tax cash Flow invested Further	500,000
Assume the return of invested amt is k
Yearly return on invested amt	500000k
PV of yearly return of invested amt @10%	=500,000k/0.10
The PV of return of invested amount should be $55,000,000 to justify investment
Or 500,000*k/0.10=55,000,000
or , 500,000k= 55,00,000
k= 11
K=1100%
so yearly return =5,500,000
Therefore the required return from Up & Coming's
new investments need to be 1100%
to justify 60 M price
This solution is provided with detailed explanation. Please discuss in case of Doubt.
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