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Estimating the fair value of a firm

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You are evaluating the potential purchase of a small business currently generating $42,500 of after-tax cash flow (D=42,500). On the basis of a review of similar-risk investment opportunities, you must earn an 18% rate of return on the proposed purchase. Because you are relatively uncertain about future cash flows, you decide to estimate the firm's value using several possible assumptions about the growth rate of cash flows.

a. What is the firm's value if cash flows are expected to grow at an annual rate of 0% from now to infinity?

b. What is the firm's value if cash flows are expected to grow at a constant annual rate of 7% from now to infinity?

c. What is the firm's value if cash flows are expected to grow at an annual rate of 12% for the first 2 years, followed by a constant annual rate of 7% from year 3 to infinity?

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a. What is the firm's value if cash flows are expected to grow at an annual rate of 0% from now to infinity?

Growth Rate=g=0%
Required rate of return=r=18%
Current Cash Flow=Do=$42500
Value of firm=Do*(1+g)/(r-g)=42500*(1+0%)/(18%-0%)=$236,111.11

b. What is the firm's value ...

Solution Summary

Solution describes the steps to estimate the firm's value under different conditions/assumptions.

$2.19
See Also This Related BrainMass Solution

Determine the fair value of stocks in the given cases.

1. Computerplus company already paid a $6 dividend per share this year and expects dividends to grow 10% annually for the next four years and 7% annually thereafter. Compute the Price of the companies stock (Note: the required rate of return on this stock is 11%).

2. The chairman of World Food Corporation announced that the firm's dividends will grow at a rate of 18% for the next three years, and that thereafter the annual rate of growth is expected to be only 6%. The annual dividend per share is estimated to be $4 in the next year. If a required rate of return of 15% is assumed, what is the highest price you are willing to pay for a share of World Food Corporation's common stock?

3. The last dividend paid by stock A was $2 per share. With a 9% required rate of return, calculate the market value of this stock if the company has no growth in the future.

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