Question

NONCONSTANT GROWTH VALUATION

Holt Enterprises recently paid a dividend, D0, of $2.75. It expects to have nonconstant growth of 18% for 2 years followed by a constant rate of 3% thereafter. The firm's required return is 17%.

Q1: How far away is the horizon date?

A: The terminal, or horizon, date is the date when the growth rate becomes nonconstant. This occurs at time zero.

B: The terminal, or horizon, date is the date when the growth rate becomes constant. This occurs at the beginning of Year 2.

C: The terminal, or horizon, date is the date when the growth rate becomes constant. This occurs at the end of Year 2.

D: The terminal, or horizon, date is infinity since common stocks do not have a maturity date.

E: The terminal, or horizon, date is Year 0 since the value of a common stock is the present value of all future expected dividends at time zero.

Q2: What is the firm's horizon, or continuing, value? Round your answer to two decimal places. Do not round your intermediate calculations. $ ___________

Q3: What is the firm's intrinsic value today, P̂0? Round your answer to two decimal places. Do not round your intermediate calculations. $ ___________

Answer 1

Q1 . Non constant model for valuation consists of a period of high or supernormal growth rate for few years and after that growth stabilises to a constant slower growth rate. Value of a stock or firm is the present value of its future cash flows. Future cash flows for high growth period can be forecasted using current cash flow and high growth rate. Date at which growth rate slows down and becomes constant is called as terminal date or horizon date. In this question there is high growth rate in year 1 and year 2. At the end of year 2, growth rate slows to become constant at 3% forever and cash flows beyond year 2 will be calculated using constant slower growth rate. Hence Horizon date or terminal date occurs at end of year 2

Answer is C:The terminal or Horizon date is the date at when growth rate becomes constant. This occurs at end of year 2

Q2 Current dividend = D0 = 2.75, High growth rate = 18%

Dividend in year 1 = D1 = D0 ( 1 + high growth rate) = 2.75 (1 +18%) = 2.75 x 1.18 = 3.245

Dividend in year 2 = D2 = D1 (1 + high growth rate) = 3.245 (1 + 18%) = 3.245 x 1.18 = 3.8291

Constant growth rate after terminal date = g = 3%,, Required rate of return = r = 17%

According to constant growth rate model

Horizon value at end of year 2 = H = [D2 ( 1 + g)] / ( r - g) = [3.8291 ( 1 + 3%)] / ( 17% - 3%) = (3.8291 x 1.03) / 14% = 3.9439 / 14% = 28.1707 = 28.17

Horizon value = $28.17

Q3 Intrinsic value = P0 = Present value of future cash flows

P0 = D1 / ( 1 + r) + D2 / ( 1 + r)² + H / ( 1 + r)²

P0 = 3.245 / (1 + 17%) + 3.8291 / ( 1 + 17%)² + 28.17 / ( 1 + 17%)²

P0 = 2.7735 + 2.7972 + 20.5785 = 26.1492 = 26.15

Hence Intrinsic value = $26.15