Question

1. Hewlett-Packard’s (HP) expected dividends for the coming year are $0.60 and expected earnings per share are $0.80. The required rate of return for HP is 15%. HP’s ROE is 18% and plowback ratio is 25%.
   1. Using the constant-growth dividend discount method, calculate the firm’s intrinsic value. (10 points)

2. Calculate the present value of growth opportunities for HP. (10 points)

3. Suppose you found a positive PVGO for HP. In this case, should the firm continue with its current dividend policy or should it instead pay out 100% of earnings as dividends?   (5 points)

Answer 1

(A)

Required Return = 15%, Plowback Ratio = 25 %

Expected Dividends = $ 0.6 and Expected Earnings = $ 0.8

Growth Rate = ROE x Plowback Ratio = 18 x 0.25 = 4.5 %

Firm's Intrinsic Share Price = 0.6 / (0.15 - 0.045) = $ 5.71429 ~ $ 5.71

(B)

If none of the earnings are plowed back, then the firm has dividends equal to earnings and presents a scenario wherein the firm has no-growth.

Expected Earnings = $ 0.8 and Required Return = 15 %

Therefore, No-Growth Intrinsic Share Price = 0.8 / 0.15 = $ 5.33

PVGO (Present Value of Growth Opportunities) = 5.71 - 5.33 = $ 0.38

(C) As the present value of growth opportunities is positive, it implies that the reinvestments (plow back) being made into the business are generating positive value for the firm. Therefore, the firm should keep up with its existing dividend policy.