Blue Ocean Ltd. owns a 25% common share interest in Red Ocean Ltd. Blue Ocean acquired the shares nine years ago through a financing transaction. Each year, Blue Ocean has received a dividend from Red Ocean. Red Ocean has been in business for 50 years and continues to have strong operations and cash flows. Blue Ocean must determine the fair value of this investment at its year end. Since there is no market on which the shares are traded, Blue Ocean must use a discounted cash flow model to determine fair value.

Blue Ocean management intends to hold the shares for five more years, at which time they will sell the shares to a shareholder of Red Ocean under an existing agreement for $1 million. There is no uncertainty in this amount. Management expects to receive dividends of $80,000 for each of the five years, although there is a 20% chance that dividends could be $50,000 each year. The risk-free rate is 4% and the risk-adjusted rate is 6%.

Required: (Total: 30 marks)

1. List 3 items that Blue Ocean will need to consider in determining the fair value of the investment.

2. Calculate the fair value of the investment in Red Ocean using the traditional approach. Hint: To support you in your calculation, the factor tables are located in Appendix A at the back of your textbook. You will need to use table PV.1 and PV.2 for this calculation.

3. Calculate the fair value of the investment using the expected cash flow approach.