Question

Hoda Inc. owns 25% of the common shares of Willard Corp. The other 75% of the shares are owned by the Willard family. Hoda acquired the shares eight years ago through a financing transaction. Each year, Hoda has received a dividend from Willard. Willard has been in business for 60 years and continues to have strong operations and cash flows. Hoda must determine the fair value of this investment at its year end. Since there is no market on which the shares are traded, Hoda must use a discounted cash flow model to determine fair value.

Hoda management intends to hold the shares for five more years, at which time they will sell the shares to the Willard family under an existing agreement for $1 million. There is no uncertainty in this amount. Management expects to receive dividends of $80,000 for each of the five years, although there is a 20% chance that dividends could be $50,000 each year. The risk-free rate is 4% and the risk-adjusted rate is 6%.

Instructions

a.  Identify some of the items Hoda will need to consider in determining the fair value of the investment.

b.  Calculate the fair value of the investment in Willard using the traditional approach.

c.  Calculate the fair value of the investment using the expected cash flow approach.

d.  In this case, which discounted cash flow model is the best? Why?

Answer 1

(a)-Items that will need to consider in determining the fair value of investment:-

1. Sale value of shares at the end of 5 years

2. Risk adjusted rate

3. What is the expectation and their probability of dividend earning.

(b) Traditional Approach- Fair value= $10,00,000+[(80000*0.80)+(50000*0.20)]*5=$1370000

(c) Cash Flow Approach:- Fair Value:- 10,00,000PVIF(10%,5)+ [(80000*0.80)+(50000*0.20)]*PVAF(10%,5)=620921+280518=$901439

(d)Discounted cash flow is better by using fair value method because it tells us the exact value which is the maximum price we should pay otherwise above than we will occur loss at martket rate difference.