Note on Compound Growth

If you are considering depositing money in an interest-bearing account, then the interest rate on that account is just the rate at which your money grows, assuming you don't remove any of it. If that rate is 10 percent, then each year you simply have 10 percent more money than you had the year before. In this case, the interest rate is just an example of a compound growth rate.

The way we calculated future values is actually quite general and lets you answer some other types of questions related to growth. For example, your company currently has 10,000 employees. You've estimated that the number of employees grows by 3 percent per year. How many employees will there be in five years? Here, we start with 10,000 people instead of dollars, and we don't think of the growth rate as an interest rate, but the calculation is exactly the same:

10,000 X 1.035 = 10,000 X 1.1593 = 11,593 employees

There will be about 1,593 net new hires over the coming five years.

To give another example, according to Value Line (a leading supplier of business information for investors), Wal-Mart's 2000 sales were about $200 billion. Suppose sales are projected to increase at a rate of 15 percent per year. What will Wal-Mart's sales be in the year 2005 if this is correct? Verify for yourself that the answer is about 402.3 billion, just over twice as large.

Dividend Growth

The TICO Corporation currently pays a cash dividend of $5 per share. You believe the dividend will be increased by 4 percent each year indefinitely. How big will the dividend be in eight years?

Here we have a cash dividend growing because it is being increased by management, but, once again, the calculation is the same:

The dividend will grow by $1.84 over that period. Dividend growth is a subject we will return to in a later chapter.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

III. Valuation of Future Cash Flows

5. Introduction to Valuation: The Time Value of Money

© The McGraw-Hill Companies, 2002

PART THREE Valuation of Future Cash Flows

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