Question

Assuming that a company will remain a single entity into a foreseeable future. Based on the company’s current profit of $3.25 billion (which has yet to be paid out to shareholders) and the log-term interest rate of 5.25% per year, determine the company’s present value under the following annual profit growth scenarios:

Annual profit growth rate of 8.5%. Show your steps and manual calculations.

Annual profit growth rate of 3%. Show your steps and manual calculations.

No annual profit growth. Clearly show your steps and manual calculations.

Profits decline at an annual rate of 2.5%. Show your steps and calculations.

What conclusions can you draw from this problem?

Answer 1

Present Value = Cash flow / ((1 + interest rate) ^ number of years

Scenario 1

Annual profit next year = 3.25 x 1.085 = $3.52625 billion

Present value = 3.5625 / ((1 + 0.0525) ^ 1) = $3.35 round off

We can see that the present value will be = Current Profit x (1 + (Annual growth - Interest rate))

Present value in scenario 1 = 3.25 x (1 + (0.085 - 0.0525)) = $3.35 billion

Present value in scenario 2 = 3.25 x (1 + (0.03 - 0.0525)) = $3.18 billion

Present value in scenario 3 = 3.25 x (1 + (0.00 - 0.0525)) = $3.08 billion

Present value in scenario 4 = 3.25 x (1 + (-0.025 - 0.0525)) = $2.99 billion

Conclusion can be drawn that if the annual profit growth rate is higher than the prevailing interest rates then the present value of future profits would be greater than the current profit and vice versa.