Question

Problem 6-27 Constant Perpetual Growth Model (LO1, CFA6) Beagle Beauties engages in the development, manufacture, and sale of a line of cosmetics designed to make your dog look glamorous. Below you will find selected information necessary to compute some valuation estimates for the firm. Assume the values provided are from year-end 2015. Also assume that the firm's equity beta is 1.40, the risk-free rate is 2.90 percent, and the market risk premium is 7.8 percent. Dividends per share Return on equity Book value per share 4.20 16.50% $17.95 Earnings 6.80 14.90 Cash Flow Sales $26.55 2015 value per share Average price multiple Forecasted growth rate 7.50 9.96 3.08 8.42% 13.84% 12.31% a. What are the sustainable growth rate and required return for Beagle Beauties? (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places.) Sustainable growth rate Required return b. Using these values, estimate the current share price of Beagle Beauties stock according to the constant dividend growth model. (Do not round intermediate calculations. Round your answer to 2 decimal places.) Share price

Answer 1

a) Dividend per share for 2015 = D0 = $4.20, Earnings per share for 2015 = E0 = $6.80

Dividend Payout ratio = D0 / E0 = 4.20 / 6.80 = 0.6176

Retention ratio = 1-Dividend payout ratio = 1 - 0.6176 = 0.3824

Return on Equity = 16.50%

We know that

Sustainable growth rate = g = Return on Equity x Retention ratio = 16.50% x 0.3824 = 0.063096 = 6.3096% = 6.31% (Rounded to two decimal places)

Hence Sustainable growth rate = 6.31%

Now using Capital Asset Pricing Model

Required return of stock = r = Risk free rate + Beta x market risk premium = 2.90% + 1.40 x 7.80% = 2.90% + 10.92% = 13.82%

Hence Required return = 13.82%

b) Using Constant dividend growth model, we get

Current share price of stock = Stock price at end of 2015 = [D0(1+g)] / (r-g) = [4.20(1+6.3096%)] / (13.82%- 6.3096%) = 4.4650 / 7.5104% = $59.4508 = $59.45 (rounded to two decimal places)

Current Share price of stock = $59.45