Weekly Challenge 4

You are trying to estimate the terminal value for a firm at the end of year 5. The firm is expected to have after-tax operating earnings of \$ 250 million year 6 and these earnings are expected to grow 4% a year in perpetuity. The firm is also expected to have a return on capital of 12% and a cost of capital of 10% in perpetuity.

a. Estimate the terminal value of the firm at the end of year 5.

b. Estimate the terminal value of the firm at the end of year 5, if the return on capital is expected to be 15% after year 5.

c. Keeping the return on capital at 15%, estimate the terminal value if the expected growth rate after year 5 drops to 2%? What if the expected growth rate drops to 0%?

d. Estimate the terminal value of the firm at the end of year 5, if the return on capital is expected to be 10% after year 5.

e. Keeping the return on capital at 10%, estimate the terminal value if the expected growth rate after year 5 drops to 2%? What if the expected growth rate drops to 0%?

f. Based on the answer to the above, what is the relationship between excess returns and expected growth?