A few years ago a subsidiary of Stanley Works offered to purchase another company for $54.3 million in order to diversify its business. One way to value an entire company is to find the present value of the annual cash flows generated by the company.
a. How large would the annual cash flows (after-tax) have to be in order to justify Stanley’s purchase price if they were discounted at 18% and continued indefinitely with no growth?
b. Assume that the first annual cash flow (one year after acquisition) was expected to be $8.0 million, but it would then grow at a constant annual growth rate (indefinitely). If Stanley’s required rate of return (discount rate) was 18%, how large would the growth rate have to be in order to justify the purchase price?