Question

The Digital Growth Corp. (DG) pays no dividends currently and is not expected to for the next five years. Its latest EPS was $10, all of which was reinvested in the company. The firm's expected ROE for the next 5 years is 20% per year, and during this time it is expected to continue to reinvest all of its earnings. Afterward, the firm's ROE on new investments is expected to fall to 15%, and the company is expected to start paying out 40% of its earnings in cash dividends, which it will continue to do forever after. DG's market capitalization rate (i.e. k) is 15% per year.

a.) Draw a time line showing EPS and dividends over time (show at least 7 years).

b.) Estimate DG's intrinsic value per share.

c.) If DG was expected to pay out only 20% of earnings, how would DG's intrinsic value be affected?

d.) Suppose DG's market capitalization rate increased to 16%. What dividend policy (i.e. payout rate) would maximize DG's stock price? You can answer this question qualitatively; there is no need to do any calculations

Answer 1

(a)

|--------|----------|-----------|------------|-----------|------------|-------------|-------------|--------

0 1 2 3 4 5 6 7 8

10 12 14.4 17.28 20.736 24.883 27.122 29.563 32.224

0 0 0 0 0 0 10.8491 11.8255 12.8898 DPS (40% OF EPS)

(b)