Question

Ord Construction Company’s debt yields 8% and composes 25% of its overall capital structure. Ord Construction just paid $2 in dividends per share. The dividends of the company are expected to grow at the rate of 25% for the next 5 years. From year 6 onwards, the average growth rate of dividends for the company is expected to decline to 7% per year. The company’s estimated beta is 1.4. Assume that the expected return on the S&P 500 index, which you use as a proxy for the market portfolio, is 12%, and the risk free rate is 2%.

a. Calculate Ord Construction’s return on equity. b. What should Ord Construction’s price per share be? c. What would be the price of Ord Construction’s stock if the company did not grow and maintained its dividends at the current level of $2 per share? d. What is the present value of Ord Construction’s growth opportunities (PVGO)? e. Assuming a 21% corporate tax rate, calculate Ord Construction’s weighted average cost of capital.

Answer 1

a. Calculate Ord Construction’s return on equity.

We can calculate return on equity using CAPM formula,

Return on equity = Risk free rate + Beta(Market return - risk free rate)

Return on equity = 2% + 1.4(12% - 2%)

Return on equity = 16%

b. What should Ord Construction’s price per share be?

We can calculate the current price per share using Gordon's growth model.

P0 = D0(1+g) / (r-g)

D0 = $2

D5 = D0(1+g)^5 = 2(1+0.25)^5 = 6.10

P5 = D5*(1+g) / (r-g)

P5 = 6.10*(1.07) / (0.16 - 0.07) = $72.56

P0 = P5 / (1+r)^5 = 72.56 / (1+0.16)^5 = $34.548 or $34.55(approx)

Hence the current price is $34.55.

c) If dividend were constant, then current price can be calculated as

P0 = D / r

P0 = 2 / 0.16 = $12.5

Hence if the dividends were to remain constant, the price of the share will be $12.5.

d) PVGO

PVGO = Value of stock – value no growth

Value of stock = $34.55

Value of stock(no growth) = $12.5

PVGO = 34.55 - 12.5 = $22.05

Hence Present value of Growth Opportunity(PVGO) is $22.05

e) WACC

Weightage of debt in capital structure = 25%

Weightage of debt in capital structure = 1 - Weightage of debt in capital structure = 1 - 25% = 75%

Cost of debt = 8%

Tax rate = 21%

Cost of equity = 16%

WACC = Weightage of equity * Cost of equity + Weightage of debt * Cost of debt * (1 - Tax rate)

WACC = 0.75 * 16% + 0.25 * 8% * (1 - 0.21)

WACC = 12% + 1.58% = 13.48%

Hence WACC is 13.48%.

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