3. You love rock-climbing and the thought of running a business... so you are thinking about combining your two passions and purchasing a mountain guide company! You have found an established business that can be purchased for $14 million.1 You realize that there are different possible outcomes for this business. If mountain climbing becomes more popular (probability 35%), the business will generate FCFS of $2.5 million next year, with growth of 4% into perpetuity. If the popularity stays constant (probability 35%), FCFS from the business will be $1.2 million next year with 2% growth into perpetuity. Andif its popularity declines (probability 30%), it will generate only $0.5 million per year in FCF into perpetuity (with no growth). In analyzing this investment, you discover that you can purchase an option today to sell the company back to the current owners after exactly one year for $12.1 million. But to obtain this option, you would have to purchase the business for $16 million instead of $14 million. The discount rate for this investment is 12%. What should you do regarding this business opportunity? (20 pts)

Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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I need help with better explanation of how to do this problem. I have an answer, but it doesn't make sense. I have to know how to do in excel

 

(note to self - MT practice S18-01)

3. You love rock-climbing and the thought of running a business... so you are thinking about combining
your two passions and purchasing a mountain guide company! You have found an established
business that can be purchased for $14 million.1
You realize that there are different possible outcomes for this business. If mountain climbing
becomes more popular (probability 35%), the business will generate FCFS of $2.5 million next
year, with growth of 4% into perpetuity. If the popularity stays constant (probability 35%), FCFS
from the business will be $1.2 million next year with 2% growth into perpetuity. Andif its popularity
declines (probability 30%), it will generate only $0.5 million per year in FCF into perpetuity (with
no growth).
In analyzing this investment, you discover that you can purchase an option today to sell the company
back to the current owners after exactly one year for $12.1 million. But to obtain this option, you
would have to purchase the business for $16 million instead of $14 million.
The discount rate for this investment is 12%. What should you do regarding this business
opportunity? (20 pts)
Transcribed Image Text:3. You love rock-climbing and the thought of running a business... so you are thinking about combining your two passions and purchasing a mountain guide company! You have found an established business that can be purchased for $14 million.1 You realize that there are different possible outcomes for this business. If mountain climbing becomes more popular (probability 35%), the business will generate FCFS of $2.5 million next year, with growth of 4% into perpetuity. If the popularity stays constant (probability 35%), FCFS from the business will be $1.2 million next year with 2% growth into perpetuity. Andif its popularity declines (probability 30%), it will generate only $0.5 million per year in FCF into perpetuity (with no growth). In analyzing this investment, you discover that you can purchase an option today to sell the company back to the current owners after exactly one year for $12.1 million. But to obtain this option, you would have to purchase the business for $16 million instead of $14 million. The discount rate for this investment is 12%. What should you do regarding this business opportunity? (20 pts)
Expert Solution
Step 1

There are three different outcomes with difference in the expected future free cash flows.

Scenario 1 (Popular):

Probability of 35%, free cash flow next year of $2.5 million which will grow at a rate of 4% in to perpetuity.

Value of the free cash flow () is calculated as below:

$2500000
V =
r-g
$2500000
0.12-0.04
$3,12,50,000
Step 2

Scenario 2 (Constant):

Probability of 35%, free cash flow next year of $1.2 million which will grow at a rate of 2% in to perpetuity.

Value of the free cash flow () is calculated as below:

$1200000
r-g
$1200000
0.12-0.02
$1,20,00,000
Step 3

Scenario 3 (declines):

Probability of 30%, free cash flow next year of $0.5 million forever.

Value of the free cash flow () is calculated as below:

$500000
r-g
$500000
0.12
$41,66,666.66666667
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