Question

3. Pavlova Corp currently has 5,000,000 shares. It will generate net income of $120,000,000 1 year from now and will pay out 30% of that income in dividends. The reinvested earnings will generate an annual return of 11%. Pavlova will again pay out 30% of its earnings at year 2 and again will earn 11% on the new investment. At year 3 and every year thereafter, Pavlova will pay out 90% of its earnings and will earn 8.2% on the reinvested earnings. If Pavlova's equity cost of capital is 8%, what is its share price?

Answer 1

Solution:

Calculation of share price:

Dividend per share for year 1(D1)=(Net Income*Payout ratio)/No. of shares outstanding

=$120,000,000*30%)/5,000,000

=$7.2

Growth rate for year 2=Retention ratio*Return

=(100-30)*11%

=7.7%

Dividend for 2nd year(D2)=Dividend for fisrt year(1+growth rate)

=$7.2(1+0.077)=$7.7544

Growth rate in year 3 and thereafter=Retention ratio*Return

=(100-90)*8.2%

=0.82%

Dividend for 3rd year(D3)=D2(1+growth rate)

=$7.7544(1+0.0082)

=$7.82

Dividend for 4th year(D4)=$7.82(1+0.0082)=$7.88

Stock price at the end of year 3rd(Terminal value) is;

=D4/Cost of equity-Growth rate

=$7.88/(8%-0.82%)

=$110.70

Now,Share Price shall be sum of present value of dividend and terminal value,which is calculated as follow;

Share Price=D1/(1+cost of equity)^1+D2/(1+cost of equity)^2+D3/(1+cost of equity)^3+Terminal value/(1+cost of equity)^3

=$7.2/(1+0.08)+$7.7544/1+0.08)^2+$7.88/(1+0.08)^3+$110.70/(1+0.08)^3

=$107.45

Thus share price is $107.45