Question

Selected Financial Ratios for KO

EPS-4.00

DPS-2.00

Net Income/Sales-3%

Total Asset Turnover-3.0X

Asset/Equity-2.0

Acid Test Ratio-1.0

Income Tax Rate-45%

Current Price-$65

Beta-2.0

RF-4%

Market Return-10%

Compute the price of KO using the dividend discount model?

What will happen to the price of KO if the total asset turnover increases to 4X, net profit margin increases to 4% and beta increase to 2.5?

Answer 1

Price = current DPS * (1 + growth rate) / (required return - growth rate)

growth rate = ROE * (1 - (DPS / EPS))

ROE = (Net Income/Sales) * Total Asset Turnover * Asset/Equity

growth rate = 3% * 3.0 * 2.0 * (1 - (2.00 / 4.00))

growth rate = 9%

required return = RF + (beta * (Market Return - RF))

required return = 4% + (2.0 * (10% - 4%))  

required return = 16%

Price = 2.00 * (1 + 9%) / (16% - 9%)

Price = 31.14

After changes

growth rate = ROE * (1 - (DPS / EPS))

ROE = (Net Income/Sales) * Total Asset Turnover * Asset/Equity

growth rate = 4% * 4.0 * 2.0 * (1 - (2.00 / 4.00))

growth rate = 16%

required return = RF + (beta * (Market Return - RF))

required return = 4% + (2.5 * (10% - 4%))  

required return = 19%

Price = current DPS * (1 + growth rate) / (required return - growth rate)

Price = 2.00 * (1 + 16%) / (19% - 6%)

Price = 77.33