Question

1. Firm reinvests 60% of its earnings in projects with ROE of 10%, the capitalization rate is 15%. Earnings of $5/share. The expected year-end dividend is $2/share
2. Calculate its price us constant dividend growth model
3. Calculate the present value of growth opportunity

Answer 1

a.

Given

Reinvestment = 60%

ROE = 10%

Capitalization rate = 15%

Earnings per share EPS = $5

Dividend D = $2 per share

b.

Formula of Constant Dividend growth model

P = D/ (r-g)

Growth rate g = ROE * Reinvestment = 10% * 0.6 = 6%

r = Capitalization rate = 15%

P = 2/ (0.15-0.06) = $22.22

Therefore current price of share = $22.22

c.

Present Value of Growth Opportunity (PVGO)

PVGO = Price of share – No growth value

PVGO = Price of share – (EPS/ Capitalization rate)

PVGO = $22.22 –($5/0.15) = -$11.11

Present Value of Growth Opportunity (PVGO) = -$11.11