Seven years ago, after 15 years in public accounting, Steve Booker, CPA, resigne

Question

Seven years ago, after 15 years in public accounting, Steve Booker, CPA, resigned his position as manager of cost systems for Davis, Cohen, and O’Brien

Public Accountants and started Track Software, Inc. In the 2 years preceding his departure from Davis, Cohen, and O’Brien, Stanley had spent nights and weekends developing a sophisticated cost-accounting software program that became Track’s initial product offering. As the firm grew, Stanley planned to develop and expand

the software product offerings, all of which would be related to streamlining the accounting processes of medium- to large-sized manufacturers.

Although Track experienced losses during its first 2 years of operation—2009 and 2010—its profit has increased steadily from 2011 to the present (2015). The firm’s profit history, including dividend payments and contributions to retained earnings, is summarized in Table 1.

Stanley started the firm with a $100,000 investment: his savings of $50,000 as equity and a $50,000 long-term loan from the bank. He had hoped to maintain his initial 100 percent ownership in the corporation, but after experiencing a $50,000 loss during the first year of operation (2009), he sold 60 percent of the stock to a group of investors to obtain needed funds. Since then, no other stock transactions have taken place. Although he owns only 40 percent of the firm, Stanley actively manages all aspects of its activities; the other stockholders are not active in management of the firm. The firm’s stock was valued at $4.50 per share in 2014 and at

$5.28 per share in 2015.

A.

Track Software paid $5,000 in dividends in 2015. Suppose that an investor approached

Stanley about buying 100% of his firm. If this investor believed that by owning the company he could extract $5,000 per year in cash from the company

in perpetuity, what do you think the investor would be willing to pay for the firm

if the required return on this investment is 10%?

Explain answer

Explanation / Answer

Answer:

Price of Stock till perpetuity that gives a constant return is equal to the present value to the constant returns that will be received till perpetuity. The Price of Stock giving a constant return till perpetuiycan be calculated by discounting the future cash inflows using the discount rate at the required rate of return on investment, that is by using the following formula;

Price of Stock = Constant Dividend or return / Required rate of return

here, Price of Stock = $ 5,000 / 10% = $ 50,000

Therefore, the investor will be willing to pay $ 50,000 to earn a constant cash return of $ 5,000 per annum till perpetuity.

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