Question

. Digital Audio (DA) generates EPS of $9.00 on its existing assets and DA does not invest except to maintain the existing assets. The EPS is expected to remain constant at $9.00 per year. However, starting next year DA has the opportunity to invest $5.00 per share per year in developing new technology. Each investment is expected to generate a permanent 24% return (ROE). The technology will be fully developed after five years, so DA can repeat these investments for only five years. The first investment starts next year. Assume that the cash flow from each investment arrives at the end of the year. Investors require a 12% rate of return. 1. What will be the stock price and the P/E ratio without the new investment project? 2. Calculate the present value of the growth opportunity (PVGO). 3. Calculate the stock price and the P/E ratio with the project.

Answer 1

Since nothing has been mentioned about the dividend payout, hence we can assume that payout is 100% and EPS = Dividend

Using Gordan Growth Model:

Part A: Price of share = Dividend $9 / Cost of Equity 12% i.e. $75

Now, if the company has an investment opportunity which is going to generate returns 25% > Cost of equity 12%, this is going to increase the value for the shareholders and hence will increase the price of the stock.

Note: Present value of Terminal value = (EPS Year 6 $9 / ROE 12%)/(1+ROE 12%) ^{Number of Year 6}

Part 2:

Present Value of Growth Opportunity (PVGO) = Value of stock (with investment) - Value of stock without investment

PVGO = $83.77 - $75 i.e. $8.77 per share

Part 3:

Stock price with project = $83.77

P/E ratio = Price $83.77 / EPS $10.2 i.e. 8.212

Do let me know in case of any doubt.