Question

Question 4

Wallace, a fund manager, is evaluating common stock value of Upbox Company, a video conference platform provider. He decides to use Constant Perpetual Growth Model for the evaluation and obtains the following information related to Upbox Company and market:

Upbox Company	Market
⚫ Latest dividend per share paid: $1.5 ⚫ Earnings per share: $2.0 ⚫ Book value per share: $12.5 ⚫ Asset beta: 1.2 ⚫ Debt-to-equity ratio: 60% ⚫ Tax rate: 25% ⚫ Existing share price of common stock: $20	⚫ Risk-free rate: 2% ⚫ Market risk premium: 8%

(a) Compute the following figures:

1. (i) Sustainable growth rate.

2. (ii) Appropriate discount rate.

3. (iii) Justified value per share.

(b) Determine and explain briefly whether Wallace should buy common stock of Upbox Company.

(c) Identify THREE weaknesses for using constant perpetual growth model to evaluate stock price.

Answer 1

(A) (i) Sustainable growth rate = retention ratio * return on equity

dividend payout ratio = DPS/EPS = 1.5/2 *100 = 75%

retention ratio = 100-75 = 25% = 0.25

EPS = Book value per share * Return on equity

2 = 12.5 * return on equity

Return on equity = 2/12.5 * 100 = 16%

Sustainable growth rate = 0.25*0.16 = 0.04 = 4%

(ii) Discount rate using Capital Asset pricing Model = Risk free rate + Beta of asset ( return from market - risk free rate )

= Risk free rate + beta of asset ( Market risk premium)

= 0.02 + 1.2 ( 0.08) = 0.116 = 11.6%

(iii) Value per share using Gordon Model = D0(1+g) / ( Discount rate - growth rate )

1.5 (1+4%) / (11.6% - 4%) = 1.56 / 7.6% = $ 20.53

(B) Existing share price of the stock = 20

Fair price of stock = 20.53

20 (existing price of stock in the market) < 20.53 ( fair price)

The share of this company is undervalued and should be bought

(C) weak ness of constant perpetual growth model

- It's very rare for a dividend to have a constant growth rate in perpetuity. It does not take into account financial difficulties faced by a company

- In the formula, in denominator we have (discount rate - growth rate), if these values are equal this model will not be useful and if discount rate < growth rate denominator becomes negative, again rendering the model useless

- Exact calculation with respect to dividend, growth rate and discount rate are required for this model.

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