In: Finance
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.
(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,
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.