Question

St Lucia Green Ltd. is a company that makes eco-friendly products. It is expected that the company will achieve an EPS of AUD 10 next year. The company’s current payout ratio is 40%. The required rate of return is 17%. Its return on equity is 23%.

a) What is the share price of St Lucia Green Ltd. if it does not pursue a growth strategy?

b) Suppose St Lucia Green now has a plan to pursue a growth strategy. Calculate its share price.

c) What is the difference in share value between the no-growth strategy and the growth strategy that St Lucia Green implements?

d) What can you conclude about this difference in relation to its growth plan?

Answer 1

Part a) Share price using walter's model = [D + (r/Ke)*(E-D)]/Ke where Dividend (D) = EPS*Payout ratio = 10*40% = AUD 4; r=0.23; Ke = 0.17; EPS (E) = AUD 10

Share price = [4+(0.23/0.17)*(10-4)]/0.17 = [4+(1.352941*6)]/0.17 = (4+8.117646)/0.17 = 12.117646/0.17 = AUD 71.28

Part b)

Share price using gordon's model = [E*payout ratio]/[Ke-br] where Payout ratio = 0.4; r=0.23; Ke = 0.17; EPS (E) = AUD 10; b=retention ratio = 1-payout ratio = 1-0.4 = 0.6

Share price = [10*0.4]/[0.17-(0.6*0.23)] = 4/(0.17-0.138) = 4/0.032 = AUD 125

Part c) Differenc between share price between no growth stategy & growth stategy = AUD 125 - AUD 71.28 = AUD 53.72

Part d)

Under Gordon's model (Growth model) growth = b*r. For the profit to grow, company should make new investment and for making new investment the company should retain profits to fund it. The retention & investment alone does not ensure growth, how much return is generated on the retained money (r) is also important. Hence retention or investment & return on retention (r) creates growth (g) in profits.