Question

he 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 forever. The manager is concerned 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 $5.1 billion (which have yet to be paid out to stockholders) and the average interest rate over the past 20 years (6 percent) in each of the following profit growth scenarios:

a. Profits grow at an annual rate of 8 percent. (This one is tricky.)

Instructions: Enter your responses rounded to two decimal places.

b. Profits grow at an annual rate of 3 percent.

c. Profits grow at an annual rate of 0 percent.

d. Profits decline at an annual rate of 4 percent.

Answer 1

a) The annual growth rate of 8% is more than the interest rate of 6%. Hence the profit grow faster than interest rate, the value of the firm would be infinite. Thus there is a limitation of using simple formulas to estimate the value of a firm when the assumed growth rate is greater than the interest rate.

b) Value of Firm = [Current profit(1+i)]/(i - g)

Where i = interest rate

g = growth rate

Value of Firm = ($5.1 billion*1.06)/(0.06-0.03)

= $5.406 billion/0.03 = $180.20 billion

c) Value of Firm = [Current profit(1+i)]/(i - g)

Value of Firm = ($5.1 billion*1.06)/(0.06-0.00)

= $5.406 billion/0.06 = $90.10 billion

d) Value of Firm = [Current profit(1+i)]/(i - g)

Value of Firm = ($5.1 billion*1.06)/[0.06-(-0.04)]

= $5.406 billion/0.10 = $54.06 billion