Question

1. You are trying to value Resources Limited. Your projections for the next four years are based on the following assumptions

(Total 50 Marks)

FIN3013 August

•  Sales will be 600 million in Year 1.

•  Sales will grow at 7 percent in Years 2 and 3 and 9 percent in

  Year 4.

•  Operating profits (EBIT) will be 23 percent of sales in each year.

•  Interest expense will be 17 million in Year 1 and increase by 2 million every year until Year 4.

•  Income tax rate is 40 percent.

•  Earnings retention ratio will stay at 0.70.

•  The per-share dividend growth rate will be constant from Year 4 forward, and the final growth rate will be 300 basis points less than the growth rate from Year 3 to Year 4.

  The company has 10 million shares outstanding. The required return on the stock is estimated to be 13 percent.

1. (a) Estimate the value of the stock at the end of Year 4.

2. (b) Estimate the current value of the stock.

Answer 1

	Year 1	Year 2	Year 3	Year 4
Sales (a)	600.0	642.0	686.9	748.8
Operating Profit/EBIT (b)	138.0	147.7	158.0	172.2
Interest expenses (c)	17.0	19.0	21.0	23.0
EBT (d)=(b)-(c)	121.0	128.7	137.0	149.2
Tax @ 40%(e)=(d)*0.40	48.4	51.5	54.8	59.7
PAT(f)=(d)-(e)	72.6	77.2	82.2	89.5
Shares O/S (g)	10.0	10.0	10.0	10.0
EPS (h)=(e)/(g)	7.26	7.72	8.22	8.95
Dividend payout @ 30% (i)=(g)*0.3	2.18	2.32	2.47	2.69
Retention (j)=(h)-(i)	5.08	5.40	5.75	6.27

* All figures in the above table upto Shares outstanding or, (g)row are in million. All figures till row (g) has been rounded-off to 1 decimal place.

Sales in Year 2 is 107% of Year 1 or, 600*(1.07) or, 642 million.

Sales In Year 3 is again 107% of Year 2 or, 642*(1.07) or. 686.9 million and Sales in Year 4 is 109% of Year 3 or, 686.9*(1.09) or, 748.8 million.

Interest Expenses has increased by 2 million every year (given).

We have to caluclate the growth rate of dividend from Year 3 to Year 4 which is=(Divinded per share in year 4- Dividend per share in Year 3)/Dividend per share in Year 3*100 or, (2.69-2.47)/2.47*100 or, 8.92%.

Now, from Year 4 onwards the growth rate will be constant and it will be 300 basis point or 3% lower than the previous year growth rate i.e. (8.92-3)% or. 5.92%.

Therefore expected dividend in Year 5 will be, 2.69*(1+0.0592) or.2.85

Solution to part (a), Now applying Gordon's model estimated value of stock at the end of Year 4 should be,

P4=Dividend in Year 5/(Required Return-gowth rate) or, 2.85/(0.13-0.0592) or, 40.25 (rounded-off to 2 decimal place)

Solution to part (b), The current value of the stock will be=(Estimated value in Year 4)/(1+required rate of return)^n where,Required rate of return=13% & n=4

Putting the value in the equation, 40.2542/(1+0.13)^4 or, 24.69 (rounded-off to 2 decimal place)