Reference no: EM133127036

Phil is the founder and owner of a commercially viable company that has developed a device that saves water in the manufacturing of clothing. The firm currently generates profits of $20 million per year. Phil believes that under his management the company profits will grow at 6% per year in the future. Phil has told you that he is willing to run and own the company for the rest of his life, but would sell 90% of the company if he got an offer above $270 million and retain a 10% stake - $270 million for 90% of the company is his reservation price. 

Phil has had conversations with investment bankers that have told him that using the investment banks projected 4% per year profit growth rate, a 90% stake in the company could be sold in an initial public offering (IPO) for $450 million. The valuation data are summarized in the following table. Both Phil and the investment bankers use the Gordon Growth Model to arrive at their valuations. 

Valuation Data

Part A. 

Phil knows the economics of the business at least as well as the investment banker. Why does the investment banker's valuation assume a lower projected growth rate than Phil's expected growth rate?

Hint/Suggestion: Base your answer on material covered in the course rather than making up a story like owners always have rosier views of the future.

Part B.

Why is the investment banker's IPO valuation higher than Phil's reservation price even using a lower growth rate assumption?