Question

XYZ Corporation wants to set up a business. According to the cfo, business is looking up. As a result , the business will provide a net cahflow of $300000 for the firm during the first year and the cash flows are projected to grow at a rate of 6% per year forever. The project requires an initial investment of $4000000. The company is somewhat unsure about the assumption of a growth rate of 6% in its cash flows. At what constant growth rate would the company just breakeven if it requires a return of 12% on investment

Answer 1

Breakeven point would be at such point where Cost of Initial Investement = Preset Value of Investment Forever

Using Gordans Growth Model we put the following formula in place of Value of Investment forever whereas cost of initial investment is 4,000,000$

4000000 = {Cash Flow*(1+Growth rate(g) )/(Return on investment - Growth(g))}/(1+rate of return )^number of years

Given Rate of Return  = 12%

Cash Flow = 300,000$

Number of years = 1 (Cash flow is occuring one year from now)

4000000 = {300000*(1+g)/(0.12 - g)}/(1+.0.12)^1

4000000 = 300000*(1+g)/(0.12-g)*(1.12)

4000000/300000 = 1+g / (0.1344 - 1.12g)

13.3333 = (1+g)/(0.1344 - 1.12g)

13.3333*(0.1344 - 1.12g) = 1+g

1.7920 - 14.9333g = 1+g

1.7920 - 1 = 14.9333g + g

0.7920 = 15.9333g

g = 0.049707 or 4.9707%

Therefore the breakeven growth rate = 4.9707%