PU, INC (PUI) has the business of converting sewage
sludge into fertilize. The business is not in itself very
profitable. However, to induce PUI to remain in business, the Owner
has agreed to pay whatever amount is necessary to yield PUI a 10
percent book return on equity. At the end of the year PUI is
expected to pay a $4 dividend. It has been reinvesting 40 percent
of earning and growing at 4 percent a year.
Suppose PUI continues on this growth trend. What is the expected
long-run rate of return (r) from purchasing the stock at $100? What
part of the $100 price is attributable to the present value of
growth opportunities (PVGO)?
Now the Owner announces a plan for PUI to treat another type of
sewage. PUI’s plant will, therefore, be expanded gradually over 5
years. This means that PUI will have to reinvest 80 percent of its
earnings for 5 years. Starting in year 6, however, it will again be
able to pay out 60 percent of earnings. What will be PUI’s stock
price (Po) once this announcement is made and its consequences for
PUI are known?
Note to answer the problems above please use formulas:
r = DIVI/Po + g ; Po = EPS1/r + PVGO; Pn = DIVn/r-g; Po =
DIVI/(1+r) + DIV2/(1+r)2 +…DIVn + Pn/(1+r)n
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