You are evaluating the potential purchase of a small business currently generati

Question

You are evaluating the potential purchase of a small business currently generating RM42,500 of after-tax cash flow (D0 = RM42,500). Based on a review of similar-risk investment opportunities, you must earn an 18 percent rate of return on the proposed purchase. Since you are relatively uncertain as to future cash flows, you have decided to estimate the company's value using several possible cash flow growth rate assumptions.

a) What is the company's value if cash flows are expected to grow at an annual rate of 0 percent to infinity?

b) What is the company's value if cash flows are expected to grow at a constant annual rate of 7 percent to infinity?

c) What is the company's value if cash flows are expected to grow at an annual rate of 12 percent for the first two years followed by a constant annual rate of 7 percent from year three to infinity?

d) Briefly explain why intrinsic value is used to evaluate the desirability of financial assets.

Explanation / Answer

a)company's value =RM42,500/18% = RM236,111.11 b)company's value = RM42,500*1.07/(18%-7%) = RM413,409.09 c)company's value =42,500*1.12/1.18 +(42,500*1.12^2)/1.18^2 + ((42,500*1.12^2)*1.07/(18%-7%))/1.18^2 =RM451,063.1741 d)Because the intrinsic value is what an asset is actually worth, rather than its current market value, which is overly influenced by market conditions such as a recession or a speculative bubble.

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