Use the following information to answer the question(s)below.
Taggart Transcontinental is considering adding a trucking division to expand the coverage of its existing rail lines.The trucking division will cost $1,000,000 and is expected to generate free cash flows of $100,000 for each of the next five years.Taggart Transcontinental forecasts that future free cash flows after year 5 will grow at 2% per year,forever.Taggart Transcontinental's cost of capital is 10%.
-The continuation value for the trucking division in year five is closest to:
A)$1,000,000.
B)$1,250,000.
C)$1,275,000.
D)$1,375,000.

Question

Quizplus · Accepted Answer

To calculate the continuation value in year five, we need to find the present value of all future free cash flows beyond year five using the perpetuity formula:

Continuation Value = FCF6 / (r - g)

where FCF6 is the free cash flow in year six, r is the cost of capital, and g is the growth rate.

Since the question tells us that future free cash flows are expected to grow at a rate of 2%, we can assume that FCF6 will be $100,000*(1+0.02)=$102,000.

Plugging in the numbers, we get:

Continuation Value = $102,000 / (0.10 - 0.02) = $1,275,000

Therefore, the best choice is C).

Use the Following Information to Answer the Question(s)below