Question

11. a) The Farrow plc. corporation’s dividends per share are expected to grow indefinitely by 5% per year. i)If this year’s year-end dividend is £8 and the market capitalization rate is 10% per year, what must the current stock price be according to the Dividend Discount Model (DDM)? ii) If the expected earnings per share are £12, what is the implied value of the ROE on future investment opportunities? iii) How much is the market paying per share for growth opportunities?

Answer 1

i).

According to dividend discount model,

P0= D1/(r-g), where D1 is dividend, r is market capitalisation rate and g is dividend growth rate.

P0= 8/(10%-5%)= 8/0.05= $160

ii).

Given that earnings per share is 12. So, dividend payout ratio is 8/12= 2/3, which means retention ratio is 1-payout ratio= 1-(2/3)= 1/3.

Implied value of ROE on future investments is calculated using the formula:

g= Retention ratio*ROE

5%= (1/3)*ROE

ROE= 15%

iii).

we we can find how much market is paying for growth opportunities by using the formula:

Price of stock-(Earnings per stock/capitalisation rate)

= 160-(12/10%)

= 160-120

=40

So, Market is paying $40 per share for growth opportunities.