Question

PLEASE ANSWER QUESTIONS WITH ALL CALCULATIONS! WILL GIVE THUMBS UP ! THANK YOU !

6. Use the information below and the Two-stage Growth Model to find Axis Capital’s intrinsic value.  Forecast its cash flows from t+1 to t+3.  If its current price is $37.54, is it over or under valued?

	t	t+1	t+2	t+3	t+4
Beta	0.80
ROE		0.09	0.08	0.08	0.08
DPO		0.37	0.34	0.34	0.34
Div	$1.64

Answer 1

Answer to the question:

Current Dividend D0 = $1.64
Growth (g) = b*r
b = Retention ratio
r = ROE

Calculation of growth for each year

ROE	Retention Ratio	Growth
0.09	0.63	0.0567
0.08	0.66	0.0528
0.08	0.66	0.0528
0.08	0.66	0.0528

Calculation of the price of share

Year	Particulars	Cash Flow	PV of cash Flow @ 9.90%
1	D1 [D0*(1+g)]	1.732988	1.5769
2	D2	1.824490	1.5106
3	D3	1.920823	1.4471
3	P3	43.7714	32.976
			37.5106

P3 = D4 /Re-g
      = 2.02224 / 0.099-0.0528
    = 43.7714

Conclusion: Price of the share is 37.5106 as calculated above and current price as given in the question is          $37.54, hence there is only nominal difference of 0.03, hence we can say that share is correctly valued and this difference is on account of rounding off of cash flows and there is no mispricing of shares.

Note : 1) Calculation of cost of equity (Ke):

Since in the given question cost of the equity is not given, we have to first calculate the cost of equity with the help of price given in question.

Price today = D1 / Ke – Growth
    $37.54 = 1.732988 / Ke – 0.0528
                  on solving above we get that ke = 9.90%   

Note : 2) In the given question Ke (cost of equity) is not given, but beta is given and with the help of beta Ke can be calculated with CAPM method, but due to absence of information of Risk free rate and Market risk premium Ke can not be calculated with CAPM, Hence we have to calculated Ke by above method only.