An entrepreneur develops a business plan that requires an initial investment of $2,200 million with a further investment of $2,200 million each year on an ongoing basis. Investment is expected to yield sales revenue equal to 70 percent of the investment in each of the two years following the investment. Accounting rules require the investment to be depreciated straight-line over those two years. She asks you whether you would like to invest in this business. You have a hurdle rate for investment of this sort of 9 percent per year.
a) Develop a pro forma to assist you in your valuation and calculate the value implied by the pro forma. What are the price-to-book ratio and the forward P/E ratio?
b) After running the analysis by your accountant, you find that GAAP rules require 20 percent of the projected investment each year to be expenses immediately. Revise your pro forma and find how your valuation will change.
The solution develops a pro forma to assist in the valuation and calculates the value implied by the pro forma.