Question

RNN Ltd’s earnings per share next year is expected to be $2.00 and the earnings are expected to grow at 5% p.a. for the foreseeable future. Its required rate of return on equity has been estimated to be 8% p.a. The company has a policy of reinvesting 40% of its earnings. The present value of the company's growth opportunities is closest to:

Group of answer choices $15.00 $16.70. $41.70. $25.00.

Answer 1

Expected next year earnings (E1) = $2

Reinvesting rate = 40%

Expected next year reinvestment = $2 x 40% = $0.80

Cost of capital (K) = 8%

Growth rate of reinvestment (g) = Reinvestment rate x cost of capital = 40% x 8%= 4.8%

Using Gordon's growth model,

Present value of company's growth opportunities = E1 / (K-g)

Present value of company's growth opportunities = 0.80 / (8%-4.8%)

Present value of company's growth opportunities = $25

Therefore 4th option is correct