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 $45,500 of after-tax cash flow (D0=$45,500). On the basis of a review of similar-risk investment opportunities, you must earn a rate of return of 14% on the proposed purchase. Because you are relatively uncertain about future cash flows, you decide to estimate the firm's value using two possible assumptions about the growth rate of cash flows. a.) What is the firm's value if cash flows are expected to grow at an annual rate of 0% from now to infinity? b.) what is the firm's value if cash flows are expected to grow at a constant rate of 6% from now to infinity? c.) what is the firm's value if cash flows are expected to grow at an annual rate of 9% for the first 2 years, followed by a constant annual rate of 6% from year 3 to infinity?

Explanation / Answer

annual rate of 6% from year 3 to infinity 45,500/.14= 325,000 45,500 *(1.06)/(.14-.06)= 602,875 45500*1.09/1.14 + 45500*1.09^2/1.14^2 + 45500*1.09^2 *1.06/(.14-.06)/(1.14)^2 43,504.39 + 41,596.30 + 551,150.96 = 636,251.65

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