The potential owner/managers of the yet to be formed new In-Line Blade Company are evaluating the prospects for the business. The new equipment is expected to be $5.5 million and have after tax cash flows of $400,000 for the first two years, $750,000 in the next two years, and $1,200,000 thereafter indefinitely. The owners estimate that they require a 15% rate of return. What is the value of the In-Line Blade Company; should they go forward with the investment?
A) $3,872,122; yes.
B) $4,072,236; yes.
C) -$2,000,000; no.
D) $943,596; yes.
E) $105,185; yes.

Question

Quizplus · Accepted Answer

To calculate the value of the In-Line Blade Company, we use the discounted cash flow (DCF) method. The cash flows are $400,000 for the first two years, $750,000 for the next two years, and $1,200,000 indefinitely starting from year 5. The required rate of return is 15%.First, calculate the present value (PV) of cash flows for the first four years:- Years 1-2: $400,000 / (1.15)^1 + $400,000 / (1.15)^2- Years 3-4: $750,000 / (1.15)^3 + $750,000 / (1.15)^4Then, calculate the present value of the perpetual cash flows starting from year 5 using the formula PV = Cash Flow / (Rate of Return - Growth Rate). Since the cash flows are perpetual and constant (indicating a 0% growth rate), the formula simplifies to PV = $1,200,000 / 0.15. However, this value needs to be discounted back to present value at the end of year 4:- Perpetual cash flows PV at year 5: $1,200,000 / 0.15- Discounted back to present value at year 4: ($1,200,000 / 0.15) / (1.15)^4Finally, sum the present values of all cash flows to find the total value of the company. Compare this value to the initial investment of $5.5 million to decide whether to proceed. The correct calculation will show that the value of the company exceeds the initial investment, indicating that proceeding with the investment is financially viable. Hence, option B is correct, suggesting the company has a value that justifies going forward with the investment.

The Potential Owner/managers of the Yet to Be Formed New