Question

Aroma Coffee Corp. (ACC) has just paid $1.00 dividend. ACC plans an investment program, which will allow the company to grow its assets by 15 % per year for the next four years. The investments are finance by the retained earnings. Starting from year 5 onwards, the growth rate is expected to return to the industry’s average 6% growth rate and remain at this level in the foreseeable future. You are planning to purchase the ACC stock and estimate that the appropriate discount rate is 10%.

1. What price would you be willing to pay for the ACC stock?

2. Find the part of this price, which is due to the growth opportunities, also known as the Present Value of Growth Opportunities (PVGO).

Answer 1

Answer 1.

D0 = $1.00

Growth rate for next four years is 15%, followed by a constant growth rate (g) of 6% thereafter

D1 = $1.0000 * 1.15 = $1.1500
D2 = $1.1500 * 1.15 = $1.3225
D3 = $1.3225 * 1.15 = $1.5209
D4 = $1.5209 * 1.15 = $1.7490
D5 = $1.7490 * 1.06 = $1.8539

Required return, k = 10%

P4 = D5 / (k - g)
P4 = $1.8539 / (0.10 - 0.06)
P4 = $46.3475

P0 = $1.15/1.10 + $1.3225/1.10^2 + $1.5209/1.10^3 + $1.7490/1.10^4 + $46.3475/1.10^4
P0 = $36.13

Answer 2.

PVGO = P0 – E1 / k
PVGO = $36.13 - $1.15 / 0.10
PVGO = $36.13 - $11.50
PVGO = $24.63