17 The head of the accounting department at a major software manufacturer has as

Question

17 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 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 $2.5 billion (which have yet to be paid out to stockholders) and the average interest rate over the past 20 years (8 percent) in each of the following profit growth scenarios: Profits grow at an annual rate of 10 percent. (This one is tricky.) Profits grow at an annual rate of 3 percent. Profits grow at an annual rate of 0 percent. Profits decline at an annual rate of 3 percent.

Explanation / Answer

(a). Here, the present profit for the firm is $2.5 billion; and the profit is expected to grow at an annual rate of 10% for the next year.

So, the expected profit of the successive year will be, {$2.5 * (1 + 0.1)} billion = $2.75 billion.

If the company had put the present profit in a bank or other financial entity then the company would have earned 8% interest for the next year.

So the interest income that the firm forgo is, 8% of $2.5 billion = $0.2 billion. This will be the opportunity cost for the firm.

So, the actual valuation of the firm for the next year would be, $(2.75 – 0.20) billion = $2.55 billion.

(b). If the growth rate of profit be 3%, then the expected profit of the firm for the next year would be, ${2.5 * (1 + 0.03)} billion = $2.575 billion.

The opportunity cost of the firm is $0.20 billion; which remains the same as the interest rate does not change.

So, the actual value projection of the firm for the next year is, $(2.575 – 0.20) billion = $2.375 billion.

(c). If the growth rate of profit be 0%, then the profit of the firm in the next year will remain the same, that is, at $2.5 billion.

Since there will be an opportunity cost of $0.2 billion; so the actual profit valuation of the firm in the next year will be, $(2.5 – 0.2) billion = $2.3 billion.

This means, the firm will become worse off if she chooses to stay in the business.

(d). If the profit falls at 3% rate, then the actual profit of the firm for the next year would be,

${2.5 * (1 – 0.03)} billion = $2.425 billion.

The opportunity cost if the firm chooses to stay in the business is $0.2 billion.

So, the future year’s valuation of the firm will be, $(2.425 – 0.2) billion = $2.225 billion.

This means, in this case the firm will lose high if she chooses to stay in the business.

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