You’ve recently learned that the company where you work is being sold for $500,000. The company’s income statement indicates current profits of $25,000, which have yet to be paid out as dividends. Assuming the company will remain a “going concern” indefinitely and that the interest rate will remain constant at 9 percent, at what constant rate does the owner believe that profits will grow?
You’ve recently learned that the company where you work is being sold for $275,000. The company’s income statement indicates current profits of $10,000, which have yet to be paid out as dividends. Assuming the company will remain a “going concern” indefinitely and that the interest rate will remain constant at 10 percent, at what constant rate does the owner believe that profits will grow?
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You’ve recently learned that the company where you work is being sold for $275,000. The company’s income statement indicates current profits of $10,000, which have yet to be paid out as dividends. Assuming the company will remain a “going concern” indefinitely and that the interest rate will remain constant at 10 percent, at what constant rate does the owner believe that profits will grow?
To determine at what constant rate the owner believes that profits will grow, we can use the present value formula. The formula for the present value of perpetuity is:
Present Value = Annual Cash Flow / Interest Rate
In this case, the present value is the selling price of the company, which is $500,000. The cash flow is the current profits of $25,000 (dividends), and the interest rate is 9 percent or 0.09.
Using the formula, we can rearrange it to solve for the cash flow (profits):
Annual Cash Flow = Present Value * Interest Rate
Plugging in the given values, we have:
Annual Cash Flow = $500,000 * 0.09 = $45,000
Therefore, the owner believes that profits will grow at a constant rate of $45,000 per year.