Question
Larkspur, Inc. owns 25% of the common shares of Pronghorn Corp. The other 75% of the shares are owned by the Pronghorn family. Larkspur acquired
Larkspur, Inc. owns 25% of the common shares of Pronghorn Corp. The other 75% of the shares are owned by the Pronghorn family. Larkspur acquired the shares eight years ago through a financing transaction. Each year, Larkspur has received a dividend from Pronghorn. Pronghorn has been in business for 60 years and continues to have strong operations and cash flows. Larkspur must determine the fair value of this investment at its year end. Since there is no market on which the shares are traded, Larkspur must use a discounted cash flow model to determine fair value. Larkspur management intends to hold the shares for 5 more years, at which time they will sell the shares to the Pronghorn family under an existing agreement for $1 million. There is no uncertainty in this amount. Management expects to receive dividends of $73,500 for each of the five years, although there is a 20% chance that dividends could be $54,500 each year. The risk-free rate is 5% and the risk-adjusted rate is 7%. Click here to view the factor table PRESENT VALUE OF 1. Click here to view the factor table PRESENT VALUE OF AN ANNUITY OF 1.
Calculate the fair value of the investment in Pronghorn using the traditional approach. (For calculation purposes, use 5 decimal places as displayed in the factor table provided. Round answers to 0 decimal places, e.g. 5,275.)
Fair value of the investment |
Calculate the fair value of the investment using the expected cash flow approach. (For calculation purposes, use 5 decimal places as displayed in the factor table provided. Round answers to 0 decimal places, e.g. 5,275.)
Fair value of the investment |
In this case, which discounted cash flow model is the best?
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