Question

6. You expect that MotorRotor ltd. will have earnings per share of $2 for the coming year. MotorRotor plans to retain all of its earnings for the next three years. For the subsequent two years, the firm plans on retaining 50% of its earnings. It will then retain only 25% of its earnings from that point forward. Retained earnings will be invested in projects with an expected return of 20% per year. If MotorRotor’s equity cost of capital is 12%, then:

a) Find the price of a share of MotorRotor’s stock.

b) Assume in a different scenario that MotorRotor has just recently paid a common stock dividend of $2.35 per share. Determine the current price of a share of MotorRotor common stock if its divided growth rate is expected to remain at 7 percent per year indefinitely and its equity cost of capital remains at 12 percent.

c) Discuss the challenges of using multiples to value a company.

Answer 1

Ans a)

Years	Earnings	Dividends	g
1	$2	$0	20%
2	$2.40	$0	20%
3	$2.88	$0	20%
4	$3.46	$1.73	10%
5	$3.80	$1.90	10%
6	$4.18	$3.14	5%

P0 = 1.73 / (1.12)4 + 1.90 / (1.12)5 + (3.14 / (0.12 - 0.05)) / 1.125 = 27.63

Ans b) Stock Price = Dividend * (1 + growth rate)/(cost of equity - growth rate)

= 2.35* 1.07/(.12 - .07)

= $50.29

Ans c) Challenges of using multiples to value a compnay are as follows:

1) Volatile earning makes interpretation difficult.

2) Management discretion over accounting.

3) Size differences cause misleading comparision

4) Revenue recognition practices can distort the multiples.