Question

Ready for Takeover (RfT) is run by entrenched management that insists on reinvesting 60% of its earnings in projects that provide an ROE of 10%, despite the fact that the firm’s capitalization rate is k = 15%. The firm’s year-end dividend will be $2 per share, paid out of earnings of $5 per share. At what price will the stock sell? What is the present value of growth opportunities? Why would such a firm be ready for takeover by another firm?

Answer 1

A) Price of Stock = Dividend /(Rate - Growth*) = 2/(15%-6%*) = 22.22

* Growth = Growth = ROE * Retention ratio = 10% * 60% = 6%

B)

Present value of growth opportunity = Stock Price - Earnings/Cost of Equity = 22.22 - 5/15% = -11.11

C)

Firm price will be lower in future as price will fall in future because PVGO is negative which will cause ROE to fall which will lower its price.

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