Suppose a company has a book value of equity of $25 million, and has 1 million...

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Suppose a company has a book value of equity of $25 million, andhas 1 million shares outstanding. The company is expected to earn anet income of $5 million next year, and plans to plow back 20% ofits earnings indefinitely to grow. The company has no debt and thefirm’s equity holders require a return of 10% on their investment.With this information, answer the following three questions. (i) Ifwe assume the company will grow at a constant rate forever, what isthe value per share? (ii) Is the intrinsic value per share smalleror larger than the book value, and why? And at what P/E- ratiowould the company trade in the market today if the stock is pricedcorrectly? (iii) Now assume that the company will pay a lowerdividend of $2 per share next year, and grow this dividend at 12%for 2 years. After this period, the company will pay a dividend of$5.22, which will then grow at a rate of 4% indefinitely. How wouldthis policy affect the value per share?

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4.1 Ratings (779 Votes)

All financials in million Number of shares in million and per share data in ROE Net income Book value of equity 5 25 20 Retention ratio RR plow back ratio 20 Ke required return of 10 on their investment by equity holder i If we assume the company will grow at a constant rate forever what is the value per share The constant growth rate forever g RR x ROE 20 x 20 4 Hence total equity value Net income See Answer

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Suppose a company has a book value of equity of $25 million, andhas 1 million shares outstanding. The company is expected to earn anet income of $5 million next year, and plans to plow back 20% ofits earnings indefinitely to grow. The company has no debt and thefirm’s equity holders require a return of 10% on their investment.With this information, answer the following three questions. (i) Ifwe assume the company will grow at a constant rate forever, what isthe value per share? (ii) Is the intrinsic value per share smalleror larger than the book value, and why? And at what P/E- ratiowould the company trade in the market today if the stock is pricedcorrectly? (iii) Now assume that the company will pay a lowerdividend of $2 per share next year, and grow this dividend at 12%for 2 years. After this period, the company will pay a dividend of$5.22, which will then grow at a rate of 4% indefinitely. How wouldthis policy affect the value per share?