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Investment / Financial Markets Old Exam MFE Forum

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  #1  
Old 09-22-2019, 12:03 PM
jubair07 jubair07 is offline
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Default Rate of Growth Question

From ASM: A project requires an immediate investment of 19 million. It is expected to generate free cash flows of 2 million per year at the end of the first year, growing 2% per year perpetually. The cost of capital is 12%.
Perform a break-even analysis on the rate of growth of free cash flows.


The solution is given as :

Let g be the growth rate. We want to solve −19 + 2/(0.12-g)=0

giving g= 0.01474

Isn't g already given as 2%? Can anyone please explain the difference between g=2% and g= 0.01474 (1.474%)? Thanks!
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Old 09-22-2019, 12:35 PM
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Gandalf Gandalf is offline
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Not sure, and I donít have the textbooks or ASM. I think the idea is that the project is expected to be profitable, but they arenít sure that the growth rate will be as high as 2%. So they want to know how low the growth rate could be and the project still break even, considering the cost of capital.
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Old 09-22-2019, 10:06 PM
ambroselo ambroselo is offline
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Quote:
Originally Posted by jubair07 View Post
From ASM: A project requires an immediate investment of 19 million. It is expected to generate free cash flows of 2 million per year at the end of the first year, growing 2% per year perpetually. The cost of capital is 12%.
Perform a break-even analysis on the rate of growth of free cash flows.


The solution is given as :

Let g be the growth rate. We want to solve −19 + 2/(0.12-g)=0

giving g= 0.01474

Isn't g already given as 2%? Can anyone please explain the difference between g=2% and g= 0.01474 (1.474%)? Thanks!
g = 2% is the real growth rate of the free cash flows.

What you are asked to calculate is the growth rate such that the net present value of the project is zero. It is a hypothetical quantity generally different from the real growth rate.

Perhaps the solution can denote the break-even growth rate by another symbol like g^(break-even) to distinguish it from g = 2%. In fact, the 2% real growth rate is not required for solving the problem.
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Old 09-23-2019, 03:01 AM
jubair07 jubair07 is offline
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Thanks guys!
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