Question

FIND THE STOCK VALUE

1.A firm is expected to have a high growth rate in the next 3years and a stable growth rate of 5% a year forever after that. Use the following information to find the stock value.

Inputs for the high growth period:

Current earnings per share (EPS0) = $4.00

Current dividend per share ((DPS0) = $1.00

Length of the high-growth period = 3years

Long-term bond rate (proxy for the risk-free rate) = 5%

Market risk premium = 6%

Beta of the stock for the high-growth period= 1.7

Return on assets (ROA) during the high growth period = 23%

Debt to equity ratio during the high growth period = 0.70

Before-tax interest rate on debt for the high growth period = 7%

Tax rate during the high growth period = 25%

Inputs for the stable growth period:

Stable growth rate forever = 5%

Beta of the stock for the stable growth period = 1.1

Long-term bond rate (proxy for the risk free rate) = 5%

Market risk premium = 6%

Return on assets (ROA) during the stable growth period = 0.16

Debt to equity ratio during the stable growth period = 0.70

Before-tax interest rate on debt for the stable growth period = 6%

Tax rate during the stable growth period = 25%

Assume that the dividend payout ratio remains constant at the current level for the first three years.

Answer 1

The two-stage dividend discount model has two components:

- A high-growth phase, and ,

- A stable growth phase.

It assumes that dividends will go through two stages of growth.

Dividend growth rate (High-growth period):

Dividend growth rate for the high growth period= ROE * Retention Ratio

Where ROE= Return on Assets* Leverage(D/E Ratio)

Therefore, ROE for the high growth period= 23*0.7= 16.1%

Retention Ratio = 1- Payout ratio= 75%

Dividend growth rate for the high growth period = ROE*Retention ratio= 16.1* 0.75  = 12.08%

ROE For the Stable Growth Period:

ROE= Return on Assets* Leverage(D/E Ratio)

= 16% * 0.70= 11.2%

Inputs:

Value of stock:

Sources:

Investopedia
EfinanceMgmt