Question

4.

1. The cash flows of a firm that has just conducted an Initial Public Offering (IPO) are expected to be either £10 million per annum for 10 years and zero afterwards with probability ‘p’ or £5 million forever with probability (1-p). The risk-adjusted discount rate for this firm is 10% per annum. I. Express the current fundamental value of the firm in terms of ‘p’. II. If the current stock market value of the firm is £55 million, what is the value of ‘p’ implied by the market?

(b) The cash flows of a firm are expected to be £1 million per year starting next year for the first ten years and are then expected to start declining forever at the rate of 5% per year. The risk-adjusted discount rate is 10% per annum. What is the present value of the cash flows?

c) Investment analysts regularly prepare forecasts and reports for their clients on the valuation of the firms they follow as analysts. Briefly discuss the factors that should be taken into account in arriving at such valuations.

Answer 1

a) If the cash flow of the firm is  £10mn per year for next 10 year,

The value of the firm = Present value of all 10 years cash flow @10% discount rate=£61.45mn (calculation given below)

If the cash flow is £5mn per year,then value of the firm= 5*(1+0%)/(10%-0%)=£50mn (Using Gordons DDM model)

Value of the firm=p*61.45+50*(1-p)

If value of firm = 55,then p*61.45+50*(1-p)=55; By solving p=43.66%

b) PV of the cash= Present value of the 10 cash flow of £1mn+1*(1-5%)/(10%+5%)=6.14+6.33=£12.45mn

C) While preparing the forecast of companies financial report few points should considered very carefully:

* Companies Past performance

* Companies future growth strategy

* Management activity or whether management is good or bad for the company

* Domestic and Global economic/political situations etc.