Question

FKK LLC is expected to have 3 years more of above industry growth with 10%, 9% and 8%. Last year EPS was $10. FKK’s managers have been consistently paying half of its profits to shareholders and will keep payout ratio at this level during three years of extraordinary growth. However, as competition increases they plan to level off reinvestment rate to 25% after 3 years. In three years the broadband industry will bring on average 16% of accounting return on investment forever. Required return on equity is 12%.

1. Determine fair value of FKK's stock.
2. Evaluate management’s decision to decrease reinvestment rate in the stable period?
3. Describe the multiples approach to firm valuation. Assess the advantages and weaknesses.

Answer 1

As pee Growth model Price of share (P) = DPS, - EPS(1-b) ke-z herg where DPs is dividend pee share at year ends Re= required rate of refuenf lost of equity 8- gronette rate. 10% EPS = Earning Pee share a $10 b - Retention Ratio - 50% 1) Fair value of FKK's shock Po = 1051-0.50] 1080.5025 2$250 0.12 -0.10 0.02 Der 0.02 Fair value of FKK's stock = $250. 2 of retention ratio is decreased from 50% to 25% after 3 years. Dair value of Fkk stock if retention after Byears opos DPS, → EPS (1-b) (1+30 (1+$2)(1+93) = 10(1-0.50) (1 + 0.10)(1+0.09) CI+0.08) 6.4746 satio is 25% Pair value at year end as if b = 25% [where gabxal DPS, (I + bxr) 76.4746 (1+0.25X0.16) » 6.4746/1-04) ke-g 0.12 - 0.25% 0.16 0.08 $ 84.1698

Fair value at year endy it b=50% [ where gabxr] DPS₂ (1+ bxh) 6.4746 (1+0.5000:16) Re - bx& 0.12 - 0.50 00.16 6.4746 x 1.08 0.04 * $174.8142 The company should not increase diuidend payout to 75%. In other words seinuestment rate should not be decreased because in doing so, share value will decrease to & 84.1698 from $174.8142.1

3. Firm can also be valued using Walter Method which gives a better valuation technique for decision making in respect of dividend payout ratio and retention ratio which the company should adopt to optimize investment opportunity.

Walter Model =

-Po - DPS (EPS – DPS) = Po = K. + Ke? Ke

Weakness - It does not take into account the effect of growth rate.

Note- Growth rate (g) = b x r

where b = retention rate or reinvestment rate

and r = required rate of return.

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