Question

A). Kirk Inc. has come out with a new and improved product, and is expected to have an EPS of $3.7 and an ROE of 20%. It will maintain a plowback ratio of 27%. Investors expect a 12% rate of return on the stock. Assuming Kirk's current value is measured with the constant growth DDM, compute the present value of growth opportunities for Kirk.

*Round your answer to TWO decimal places.

B) From the earlier problem with Kirk, suppose the present value of growth opportunities = 0. If everything else remains constant, find the ROE for Kirk and explain why.

Answer 1

a. We will first compute the price (P0).

g = ROE*b = 20%*0.27 = 5.4%

D1 = 3.7*(1-27%) = 2.7010

Thus P0 = D1/(k-g) = 2.7010/(0.12 - 0.054)

= 40.9242

Now present value of growth opportunities for Kirk = P0 - E0/k

= 40.9242 - (3.7/0.12)

= $10.09

b. Here present value of growth opportunities = 0. Thus P0 - (3.7/0.12) = 0

or P0 = 30.8333

Also P0 = D1/(k-g)

or 30.83333 = 2.7010/(0.12 -g)

or (0.12 - g) = 0.0876

or g = 0.0324

We know that g = ROE*b

Thus 0.0324 = ROE*0.27

or ROE = 0.0324/0.27

= 12.00%