Graeme Owns a Profitable Small CCPC, ABC Co

question 1

Essay

Graeme owns a profitable small CCPC, ABC Co. that he started five years ago, which generated $75,000 in pre-tax profits this year. He is considering selling the company to a potential buyer, Steve, and the two are trying to determine an appropriate value. Graeme believes the profits will increase steadily in the future, while Steve is a bit more cautious in his predictions as he is aware of a strong competitor coming to town. Graeme believes that a capitalization rate of 20% is reasonable, while Steve believes that 40% would be more realistic for this type of sale. Graeme would like to use the after-tax profits from this year in the valuation. Steve would like to see the pre-tax profits reduced by 10% to reflect a potential decline in revenues. The corporate tax rate is 13%.
Required:
Calculate the difference in the two valuations that Graeme and Steve are considering for the sale of ABC Co. using the earnings method.

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Definitions:

Creditors

Individuals or institutions that lend money or extend credit to others, with the expectation of being paid back with interest.

Price-Earnings Ratio

The ratio for valuing a company that measures its current share price relative to its per-share earnings, widely used by investors to assess the market's valuation of a stock relative to its earnings performance.

Financial Statements

Reports that summarize the financial performance, position, and cash flows of a business for a specified period.

Book Values

The value of an asset as recorded on the company’s balance sheet, calculated as the cost of the asset minus any depreciation, amortization, or impairment costs.