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Using the information below, estimate the value of the business as of the first day of year 1 using both the discounted cash flow approach
Using the information below, estimate the value of the business as of the first day of year 1 using both the discounted cash flow approach AND the abnormal earnings approach. (Hint: These approaches produce the same valuation estimate).
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Case Information:
- At the beginning of year 1, Edward decides to put $1,200 into starting his own business. This amount represents beginning book value of equity. He uses the $1,200 in cash to purchase inventory of $600 and machinery costing $600.
- Edwards required rate of return on his investment (i.e., the cost of equity capital) is 10%.
- At the end of the fifth year of operations, Edward will dissolve the business. He expects to sell all of his inventory during the last year and at the end of the year will sell all of the machinery for net book value (i.e., the cash received is equal to net book value and no gain or loss is recorded).
- The company will pay out all excess cash (i.e., free cash flows) as dividends each year.
- Recall Free Cash Flow = EBIT x (1- tax rate) + Amortization and Depreciation Expense Change in Working Capital Net Capital Expenditure. EBIT is Earnings Before interest and Taxes. Note because Edward does not take out any debt, EBIT is equal to Earnings before tax expense.
- Edward forecasts the following income statement, changes in working capital, and net capital expenditures for each of the next five years.
- The tax rate is 21%.
Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
Sales | 2,000 | 2,040 | 2,122 | 2,249 | 2,474 |
Cost of Goods Sold | 500 | 551 | 594 | 607 | 823 |
Gross Profit | 1,500 | 1,489 | 1,528 | 1,642 | 1,651 |
Selling, general, and administrative Expenses | 240 | 245 | 276 | 315 | 421 |
Amortization and Depreciation Expense | 90 | 135 | 180 | 225 | 270 |
Income Before Tax Expense | 1,170 | 1,109 | 1,072 | 1,102 | 960 |
Income Tax Expense | 246 | 233 | 225 | 231 | 202 |
Net Income | 924 | 876 | 847 | 870 | 759 |
Other Information: | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
Changes in Working Capital | 50 | 99 | 31 | 43 | -823 |
Net Capital Expenditure |
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