Question

SkyTech Ltd. is expected to pay a per-share dividend next year of $30. The market’s consensus is that the firm’s dividend growth rate of 2% per year will be maintained in the foreseeable future. SkyTech’s cost of equity is 10% per year.

(a) What is the price of a share of SkyTech?                                

(b) Suppose SkyTech’s internal view is that it has an expected average yearly dividend growth of 2% because its return on equity is 8% and management retains 25% of earnings. What is the earnings per share of SkyTech next year? What is the present value of growth opportunities per share of SkyTech?                                                 

(c)    Suppose SkyTech is about to announce that it will increase its retention ratio to 50%, effective immediately. If the market is still unaware of SkyTech’s decision, what will be the new value of the stock after the change in policy? How would you invest to profit from this fact?                                                            

(d)    If the dividend policy of SkyTech Ltd. has not shown a clear relationship to its earnings growth, what other absolute valuation model can you use to value the company? What cash flows should be used in the valuation?                          

Answer 1

Ans a) $375

Price = D1/(Ke – g)

Where

D1 = Dividend Next Year

Ke = Cost of Equity

g = Growth Rate

Price = D1/(Ke – g) = 30 / (0.10 - 0.02) = 375

Ans b) EPS =$ 40 and Present value of growth opportunities per share = $1500

Retention Ration = 25%

Payout Ration = 1 - Retention Ration = 1 – 0.25 = 0.75 or 75%

Next Year Divided = $30

$ 30 is 75% of Total Earning so Total Earning per Share = 30* 100/75 = $ 40

EPS Next Year = $40

Present value of growth opportunities per share = $1500

Present value of growth opportunities per share = D1 / g

(As mentioned above growth rate of 2% per year will be maintained in the foreseeable future)

= $30 / 0.02 = 1500

Ans c) New Price = $250

If retention ratio is increased to 50%

So Next Dividend would be 50% of EPS or 50% of $ 40 = $ 20

New Price = D1/(Ke – g)

Assuming cost of equity from option a 10%

New Price = 20 /(0.10 – 0.02) = 250

How would you invest to profit from this fact?

Ans - I will short the stock or wait to get the news out and buy at lesser price.

Ans d)

Free Cash Flow to Firm and NPV of those cash flow is another approach that should be taken into consideration to value a firm if dividend policy is not presenting clear relationship with earnings.

Hope this helps.