Exercise Question 4 A firms current profits are 400000 Thes

Exercise: . Question 4: A firm\'s current profits are $400,000. These profits are expected to grow indefinitely at a constant annual rate of 4 percent. If the firm\'s opportunity cost of funds is 6 percent, determine the value of the firm:

Solution

The current profits are worth $400,000 and they are about to increase at a rate of 4 percent forever. These profits will be bearing an interest rate of 6% so on one side, 400,000 will grow to become 400,000(1+6%) next year and on the other side the actual value computed in indefinite period will be divided by the interest factor which is (0.06 - 0.04). Hence the value of the firm is

PV = 400,000(1+6%)/(0.06-0.04)

= 21.2 million. This is the value of the firm before making any payments