Mae Chen, manager of Chen Fabrics, is comparing two assumptions about the terminal cash flow arising from an expansion project. The Year 7 cash flow is $250,000. One assumption is that subsequent cash flows are constant. An equally valid assumption is that subsequent cash flows will grow at a four percent rate. If Chen Fabrics' cost of capital is 11 percent, what is the difference in the calculation of the project's terminal value?
A)Under $25,000
B)Between $250,000 and $500,000
C)Between $500,001 and $1,000,000
D)Over 1,000,000

Question

Quizplus · Accepted Answer

The terminal value under constant cash flows is calculated using the perpetuity formula: Terminal Value = Cash Flow / Cost of Capital. For constant cash flows, it's $250,000 / 0.11 = $2,272,727.27. For growing cash flows, the formula adjusts to: Terminal Value = Cash Flow / (Cost of Capital - Growth Rate), so it's $250,000 / (0.11 - 0.04) = $3,571,428.57. The difference is $3,571,428.57 - $2,272,727.27 = $1,298,701.30, which is over $1,000,000.

Mae Chen, Manager of Chen Fabrics, Is Comparing Two Assumptions