Question

c)Assuming that ROCE (return on common equity), g (the growth rate of the book value of common shareholders’ equity) and rE (the cost of equity capital) are constant, that markets are efficient, and:the company’s dividend payout ratio d is 20%,g is 8%,the company’s stock has an equity beta of 1.2,the risk free rate is 1% and the market risk premium is 6%,

what is the ROCE priced into the market?

Continuing with the information given in part (c), what will be the percentage effect onthe stock’s intrinsic value if:

(i)the market risk premium increases to 7%;

(ii)the market expectation of the dividend payout ratio changes to 50%;

(iii)the market expectation of future ROCE changes to 9%?

Try to explain the direction and magnitude of each change.

Answer 1

Given data follows below:

Assuming that ROCE (return on common equity), g (the growth rate of the book value of common shareholders’ equity) and rE (the cost of equity capital) are constant, that markets are efficient, and:the company’s dividend payout ratio d is 20%,is 8%,the company’s stock has an equity beta of 1.2,the risk free rate is 1% and the market risk premium is 6%,

ROCE priced into the market

=> 8% = 0.20 * ROCE

=> ROCE = 40%

D/P = 20%

b = 1-0.20 = 80%

g = 8%

beta = 1.20

Rf = 1%

(Rm - Rf) = 6%

Using CAPM, Re = Rf + Beta * (Rm-Rf) = 1% + 1.20*(6%) = 8.2%

Assuming ROCE, g and Re are constant

i)

Re = 1% + 1.20 *(7%) = 9.4%

Re changes by (9.4% - 8.2%) = 1.2%

ii)

b = 1 - 0.50 = 50%

g = b ROCE = 0.50 0.40 = 20%

The growth rate (g) changes (increases) by 12% i.e. (20% - 8%)

iii)

g = 0.20 * 9% = 1.8%

The growth rate (g) changes (decreases) by 6.2% i.e. (1.8% - 8%

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