Vega Music's projected net income and free cash flows are given above in thousands of dollars. Vega expects that their net income and increases in net working capital to increase by 5% per year. If Vega were able to reduce its annual increase in working capital by 10% without affecting any other part of the business adversely, what would be the effect of this reduction on Vega's value, given a cost of capital of 13%?
A) an increase of $500,000
B) an increase of $1,370,000
C) an increase of $2,500,000
D) an increase of $3,800,000

Question

Vega Music's projected net income and free cash flows are given above in thousands of dollars. Vega expects that their net income and increases in net working capital to increase by 5% per year. If Vega were able to reduce its annual increase in working capital by 10% without affecting any other part of the business adversely, what would be the effect of this reduction on Vega's value, given a cost of capital of 13%?
A) an increase of $500,000 
B) an increase of $1,370,000 
C) an increase of $2,500,000 
D) an increase of $3,800,000

Quizplus · Accepted Answer

C) Initial value = $57,000 / (0.13 - 0.05) = $712,500,000;
reducing working capital by 10%, starting working capital = 0.9 × 2,000 = 1,800;
final value = $57,200 / (0.13 - 0.05) = $715,000,000;
thus, an increase of $715,000,000 - $712,500,000 = $2,500,000

Vega Music's Projected Net Income and Free Cash Flows Are