Question

1. XYZ Company’s stock is selling for $22.50 per share. It has just announced that it will pay a $1.35 dividend later this year. Dividends are expected to grow 4.5% per year in the future. What rate of return are investors expecting to earn with an investment in XYZ?

2. Company J expects to have free cash flow (FCF) this year of $1,000,000. FCF is expected to grow at a constant rate of 3%. If company J has an 8% discount rate, debt of $15,000,000 and 400,000 shares; what is the value per share?

Answer 1

Part 1:

Rate of return expected is 10.50% as per Dividend Discount model as follows:

в с Formula D Cell reference Values 1 2 3 Groiwth rate of dividend 8 Given 4.50% 4 Next Dividend D1 Given $ 1.35 5 Current Price PO Given $ 22.50 6 Current Price PO=D1/(r-8). R= (D1/PO)+g 7 Where r= Rate of return, g= growth rate of dividend and D1= First year dividend 8 D1/PO E4/E5 0.060000 9 Rate of Return on equity r (D1/P0)+8 E8+E3 10.50%

Part 2:

Value per share= Equity value/ Number of shares.

Equity value= Firm value- Debt

Firm Value = Free Cash Flow (FCF) next year/(WACC-g)

Where WACC= Weighted cost of capital or the required discount rate and g= constant growth rate of cash flows.

Given, Free Cash Flow this year (FCF0)=$1,000,000 and growth rate=3%

Hence FCF next year= $1,000,000*(1+3%)= $ 1,030,000

Discount rate =8%

Therefore, Firm Value= $ 1,030,000/(8%-3%) = $ 20,600,000

Given that Debt of the company= $15,000,000 and Number of shares=400,000

Therefore, Value per share= ($ 20,600,000-$15,000,000)/400,000 = $14.00