Question

Summer I: 2018-2019 Mid Term E C2: As a business administration student, you are considering a potential investment in a company that appears to be of great value. a. The company is expected to earn $10.50 per share at the end of this year. If the fair rate of return for this stock is 9 percent, what is an the company pays out all earnings as dividends? b. If the company were to pay out half of its earnings as dividends and re-invest the remainder in the company to earn 11 percent, how would the value per share change? c. Interpret the difference between your answers to parts appropriate price per share for the stock if ISK2: 5 marks and b. a.

Answer 1

a) The company is expected to earn a $10.50 per share at the end of this year. If the fair rate of return for this stock is 9%, what is the appropriate price per share for the stock if the company pays out all earnings as dividends?

Answer:

Use no growth formula,

price = $10.50 / 9% = 10.5 / 0.09

= $116.66

b) If the company were to pay out half of its earnings as dividends and re-invest the remainder in the company to earn 11%, how would the value per share change?

Answer:

.g = ROE´b

= 11%´.5

= 5.5%$10.50´0.50 / (9% – 5.5%)

= $150

c) Interpret the difference between your answers to part (a) and (b).

The difference in answers to parts a. and b. is called the PVGO. It represents the value that the firm creates by reinvesting earnings in future growth opportunities.

PVGO = $150 – $116.66

= $33.34