Question

BT Alex Brown Analysts are evaluating Energen (NYSE: EGN) for possible inclusion in a small-cap oriented portfolio. EGN is a diversified energy company involved in oil & gas products. As a result of EGN’s aggressive program of purchasing oil and gas producing properties, BT Alex Brown expects above-average growth for the next five years. The analysts establish the following facts and forecasts for EGN:

• Current market price is $20
• Current dividends are $0.54
• Required return on equity is 11%
• Initial 2-year period of 15% per year earnings and dividend growth
• BT Alex anticipates that EGN can grow 7% per year as a mature company and allows 10 years for the transition to the mature growth period.

Which of the following is closest to the terminal value after 2 years?

		$32.74
		$30.31
		$20.21
		$26.25

Answer 1

By the perpetuity method, in business valuation free cash flow or dividend can be forecasted for a certain period of time after which investors assume that cash flow will grow at the stabilized growth rate.

The terminal value can be found here by H dividend discount model. Since the first two years the dividend will grow by 15% so at the end of two years the dividend will be-

0.54×1.15×1.15= 0.714

H dividend discount model is used because after 2 years of growing at 15% the company will take 10 years to stabilize into a mature company and grow at 7% thereby.

Now the H dividend discount model is

P= (D​​​​​​0​​​​​+(1+g​​​​2))/r-g2+​​​​​(D0×H×(G​​​​​1--G2))/r-g2

So for this problem D​​​​​​​​​​0 is 0.714

H= numbers of years to stabilize divided by 2=5

G1=15%=0.15

G2=7%=0.07

R=return on equity as only stock and dividend is given=11%=0.11

So putting these values, the terminal Value will be

P=26.25

So correct option is fourth one