Youve recently learned that the company
where you work is being sold for $275,000. The companys 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? Does this seem reasonable?
Answer : Initial Profit = $10,000 Cost = $275,000 interest = 10 % As . the ownwee has purchased the company for $275,000 , despite the fact that profit was just $10,000 . Therefore , according to him , the profit will grow at a rate that will balance the full cost. Total cost = $275,000 + opportunity cost =$275,000+ 10% of$275,000 = $275,000 + $27,500 = $302,500 Therefore profit must grow at a rate (g) given by : 10,000(1+g)=302,500…
10,000g = 292,500 g = 2.92 or 292% This does not seems to be reasonable as if it is possible for theprofit togrow at a rate of 292% , then the old ownwer of thecompany would not have been sold it and it is also assumed thatthe company will remain a going concern indefinitely .