Question

(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?

Answer 1

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%

Therefore,

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.