Question

A mature U.S. telecommunications company expects to pay a dividend per share of $6 next year (paid annually at the end of the year) and expects the dividend to grow at a constant rate in the future. The firm’s equity beta equals 0.65. The risk free rate is 3%, and the expected return on the stock market index is 8%. The firm reinvests 20% of its earnings at an ROE of 12.5%. The current book value per share is $60. With this information, please answer the following two questions.

3.           Determine the required return on the stock based on CAPM and calculate the intrinsic value per share for the telecommunications company. Also explain the difference between the market value and the book value per share. Motivate your answer and show your calculations.

4.            Suppose the firm wants to grow at a higher rate of 7.5% in the future. If the firm keeps its ROE at 12.5%, what would be the impact of this strategy on the dividend in the short run and the value per share? And what would be the impact on the dividends and the value per share if the firm expects to increase its ROE to 15%? Explain your answer (no calculations are needed).

Answer 1

As per CAPM Model, Re (required rate of return)

Re= Rf + (Rm-Rf) B

= 3+ (8-3)0.65

Re= 6.25%

g= b*r

g= growth rate.

b= retention ratio.

r= return on equity

g=20*12.5%

g=2.5%

D= Expected Dividend.

Intrinsic value (IV) = D/Re-g

=6/(6.25-2.5)%

=$160.

The market value per share is the price that a share can be readily bought or sold in the current market place.

Book Value is as per the Shareholders wealth in the books of accounts (balance sheet). It can be obtained by Assets - liabilities i.e. net assets.

B. These entire part is based on the formula

g= b*r.

(Please give yourself 5 minutes time and think

the answer, then verify)

1. Dividend paid will be less in short term (as b increases)

The share price will increase. (Formula of IV- G in denominator with negative sign, G increases)

2. Both Dividend and share price increases (as net income increases).  

Thank you, hope you find it helpful.