Question a) You are evaluating the potential purchase of a small business currently generating $42,500 of after-tax cash flow. On the basis of a review of similar-risk investment opportunities, you must earn an 18% rate of return on the proposed purchase. Because you are relatively uncertain about future cash flows, you decide to estimate the firm's value using several possible assumptions about the growth rate of cash flows. (i) What is the firm's value if cash flows are expected to grow at an annual rate of 0% from now to infinity? (ii) What is the firm's value if cash flows are expected to grow at a constant annual rate of 7% from now to infinity? (iii) What is the firm's value if cash flows are expected to grow at an annual rate of 12% for the first 2 years, followed by a constant annual rate of 7% from year 3 to infinity?

Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
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a) You are evaluating the potential purchase of a small business
currently generating $42,500 of after-tax cash flow. On the
basis of a review of similar-risk investment opportunities,
you must earn an 18% rate of return on the proposed
purchase. Because you are relatively uncertain about future
cash flows, you decide to estimate the firm's value using
several possible assumptions about the growth rate of cash
flows.
(i) What is the firm's value if cash flows are expected to grow
at an annual rate of 0% from
now to infinity?
(ii) What is the firm's value if cash flows are expected to
grow at a constant annual rate of
7% from now to infinity?
(iii) What is the firm's value if cash flows are expected to
grow at an annual rate of 12% for the first 2 years,
followed by a constant annual rate of 7% from year 3 to
infinity?
Transcribed Image Text:Question a) You are evaluating the potential purchase of a small business currently generating $42,500 of after-tax cash flow. On the basis of a review of similar-risk investment opportunities, you must earn an 18% rate of return on the proposed purchase. Because you are relatively uncertain about future cash flows, you decide to estimate the firm's value using several possible assumptions about the growth rate of cash flows. (i) What is the firm's value if cash flows are expected to grow at an annual rate of 0% from now to infinity? (ii) What is the firm's value if cash flows are expected to grow at a constant annual rate of 7% from now to infinity? (iii) What is the firm's value if cash flows are expected to grow at an annual rate of 12% for the first 2 years, followed by a constant annual rate of 7% from year 3 to infinity?
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