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Another Example

Firm X currently has expected earnings of $100,000 per year in perpetuity. Firm X is switching its policy and wants to invest 20% of its earnings in projects with a 10% return. The discount rate is 18%.

No-growth price: P=$100,000/0.18 = $555,555

PV(GO) is a constant growth perpetuity

What’s g? g=Investment rate x ROI = 0.2 × 10% = 2%

What is the first year’s investment cash flow?  Invest $20,000 and receive $2,000 forever

-20,000+(2,000/0.18)=-8888.89

PV(GO) = (-8,888.89)/(0.18-0.02) = - 55,555

New Policy: P=$555,555 - 55,555 = $500,000

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