(Explain each step in detail. Show your logic. Do not only provide answers and formulas.) - PLEASE SHOW FORMULAS
You are an analyst evaluating Up-and-Coming Airlines Inc., a very hot potential acquisition candidate your company is considering. Up-and-Coming currently has no debt and you estimate that it should be able to generate $1 million a year from its existing assets (after tax cash flow). Furthermore, it has the opportunity to invest one-half of its earnings indefinitely. You estimate that because of better management, your company should be able to improve the rate of return that Up-and Coming can earn on its new investment opportunities. The appropriate discount rate for Up-and-Coming’s cash flows is 10%. Up-and-Coming can be purchased for $60 million and management asks you what you think. What rate of return would Up-and-Coming have to earn on its new investments to justify such a price?
Using the Gorgon growth model, we can calculate the growth of the company in-built into a $60 million price
Value of company = After tax cash flows / (cost of equity - growth rate)
Value of company = 60 million
After tax cash flows = 1 million
cost of equity = 10%
60 = 1 / (0.1 - g)
6 - 60g = 1
g = 5 / 60 = 0.0833 = 8.33%
The sustainable growth rate of a company is the product of the percentage of earnings reinvested in business and the rate of return earned in the business. Therefore,
g = Retention ratio * rate of return earned
g = 0.0833 ..... (as computed above)
Retention ratio = 0.5 ..... (given in question)
0.0833 = 0.5 * rate of return earned
Rate of return = 0.0833 / 0.5 = 0.1667
Up-and-Coming shall have to earn a return of 16.67% to justify the price of $60million.
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