Our client ITech Geek has several questions for us to answer as their consultant firm concerning
valuation, which cash flows matter, the calculation of these cash flows, convergence to a
perpetuity, and bond pricing, among others. These are outlined below.
Question 1
ITech Geek is a publicly traded technology company and has 5,000,000 shares outstanding.
Their marginal tax rate of 30%. Assume ITech Geek plows-back 60% of its net income into
retained earnings.
First, you are to create the necessary Balance Sheets and Income Statement and then calculate
the annual Cash Flow from Assets (aka: CFFA or Free Cash Flows (FCF)) for ITech Geek. A
constraint here, however, is that your CFFA must range between $20,000,000 and $24,000,000
annually. Second, assuming ITech Geek’s annualized WACC is 8% and its annualized CFFA
are growing at 5%, you are to estimate the current value of ITech Geek.
Question 2
ITech Geek is not familiar with the mechanics of corporate bond valuation. They are interested
in the fact that bond prices converge to their PAR value as the date to maturity nears. Explain
this concept to ITech Geek management.
Question 3
We have often discussed the formulas for the present value of a perpetuity (aka: no-growth
perpetuity) and the present value of an ordinary annuity (aka: finite series of cash flows):
𝑃𝑉= 𝐶𝐹
𝑟 (I)
𝑃𝑉= ∑𝑛
𝑖= 1
𝐶𝐹
(1 + 𝑟)𝑖 (II)
With 𝐶𝐹> 0 and 0 < 𝑟< 1. We know that 𝑃𝑉= 𝐶𝐹
𝑟 converges to 𝑃𝑉= ∑𝑛
𝑖= 1
𝐶𝐹
(1 + 𝑟)𝑖 as n
approaches ∞. ITech Geek management is confused about this concept. Illustrate to ITech Geek
management that this is so and why is it important in terms of valuation.