Question

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?

Answer 1

1) -o------------1--------------2-----------------3------------------

8   8(1.15) 8(1.15)^2 8(1.15)^3 Dividend

9.2 10.58 12.1670

to find the PV of dividend at year 3 which will grow at a constand rate of 5% we have to use gordon growth model

PV3 = [12.1670(1+5%)]/(13.6%-5%) = 148.5506

to find the cost of Equity use CAPM= 4%+ 1.2(8%)= 13.6%

NOw use calculator

CF0 = 0

CF1= 9.2

CF2 = 10.58

CF3= 12.1670 + 148.5506 = 160.7176

I/Y = 13.6%

Compute NPV = 180.4976 will be teh current price of the share

2) if ROE stays the same

but Payout increase then the retention ratio will fall

hence the sustainable growth will fall