Question

Adam started a recycling and manufacturing business that requires a lot of advanced machines to reduce the cost of labor. The start up cost is estimated to be $850000. The factory expects to make no profit for the first two years and then make $100000 in the third year. The profit is expected to grow at a rate of 7% for the forseable future, the discount rate for the business is 9% what should be the value of the business now?

Answer 1

The value of the business is calculated by determining the present value of expected future cash flows, growing at 7%, and discounted at a 9% rate.

Step-by-step explanation:

The value of the business now, considering the startup cost, no profit for the first two years, and growing profits from the third year, is calculated using the present value of future cash flows. To do this, we utilize the formula for present value (PV), which is PV = C / (1 + r)^n, where C is the cash flow in a given year, r is the discount rate, and n is the year. To find the value of the business, we need to calculate the present value of the future cash flows.

The cash flows for the first two years are zero, so we start with the cash flow in the third year, which is $100,000. In Adam's case, we expect a cash flow of $100,000 starting in the third year, growing at 7% annually. An important assumption here is that the growth of 7% continues indefinitely, which allows us to use the formula for a perpetuity: PV = C / (r - g), where r is the discount rate and g is the growth rate.