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Company ABC’s beta is 1.2. The estimated market risk premium is 8% per annum and the...

    Company ABC’s beta is 1.2. The estimated market risk premium is 8% per annum and the risk-free rate is 4% per annum. The company recently paid a dividend per share of $1.00. It is expected that company can maintain a dividend growth of 15% a year for the next 3 years. Given an in-depth analysis, it comes to term that the growth rate will decline to 5% per annum and remains at that level indefinitely.

    1. Using multistage dividend discount model and the information provided above, calculate current price of the share
    2. Suppose the company’s ROE is the same and the company is expected to increase payout ratio after three years, what will be the impact on company’s sustainable growth?

    (b)

    Consider two firms producing personal protective equipment (PPE). One uses a highly automated robotics process, whereas the other uses workers on an assembly line and pays overtime when there is a heavy production demand. All else being equal,

    1. which firm will have higher profit in a recession? In a boom?
    2. which firm’s stock will have higher fixed cost and a higher beta?

    Solutions

    Expert Solution

    Solution:

    Answering question first as per Chegg's guidelines:

    1.ii)Calculation of current price of share:

    Cost of equity=Risk free rate+Beta*market risk premium

    =4%+(1.2*8%)

    =13.60%

    Dividend for 1st year(D1)=Last dividend(1+growth rate)

    =$1.00(1+0.15)=$1.15

    Dividend for year 2=$1.15(1+0.15)=$1.3225

    Dividend for year 3(D3)=$1.3225(1+0.15)=$1.520875

    Here we need to calculate the share price at the end of year 3 because dividend growth rate is constant after year 3.

    Share Price at the end of year 3(P3)=D3(1+growth rate)/(Cost of equity-Growth rate)

    =$1.520875(1+0.05)/(13.60%-5%)

    =$18.569

    Now,current share price is;

    =Present value of D1,D2 and D3+Present value of P3

    =$1.15/(1+0.1360)^1+1.3225/(1+0.1360)^2+($1.520875+$18.569)/(1+0.1360)^3

    =$15.74

    ii)Sustianable grotwth rate=ROE*(1-Payout ratio)

    If the payout ratio increases,it will result in decline in growth rate.

      


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