Question

Current forecast for Company is to have an after-tax earnings of €192 million next year. The company has 800.000 shares traded. The book value of its equity is €800 million. The company usually pays out 25% of its after-tax earnings as dividend. It is financed purely by its equity. The expected return on investment with similar level of risk is 20%

a) What is the return on equity of the company?

b) What is the constant growth rate of its earnings?

c) How much would you pay for one of its shares?

d) What is the present value of growth opportunities?

Answer 1

Given, Earnings expected= €192 Million, Book Value of equity= €800 Million and

number of shares= 800,000

Therefore, EPS1= €192 Million/800,000 = €240

Also given, pay out ratio= 25%

Part (a):

Return on Equity (ROE)= Equity earnings/Average equity

= €192 Million/€800 Million = 24%

Part (b):

Constant growth rate (g)= ROE*Retention rate.

Given, Dividend payout ratio= 25%. Therefore, retention rate= 1-25% = 0.75

Growth rate (g)= 0.24*0.75= 18%

Part (c):

Current price of the share (P0)= D1/(r-g)

Where D1= Dividend next year, r= required rate of return (given as 20%) and g= constant growth rate (18% as in part b)

D1= EPS1*Pay out ratio= €240*25% = €60

Therefore, Current price per share = €60/(0.20-0.18) = €3,000

Part (d):

Present value of growth opportunities (PVGO) per share= P0-EPS1/r

=€3,000-€240/0.20 = =€3,000-€1,200 = €1,800.