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Next year's earnings are estimated to be $2. The company plans to reinvest 25% of its earnings at...

Question:

Next year's earnings are estimated to be $2. The company plans to reinvest 25% of its earnings at 20%.

If the cost of equity is 10%, what is the present value of growth opportunities?

a. $9.00

b. $11.00

c. $10.00

d. $10.10

Present Value of Growth Opportunity:

The present value of growth opportunity is the portion of a stock's value that is attributed to growth opportunities of dividends. The present value of growth opportunities is higher for a stock that will experience a higher rate of growth in dividends.

Answer and Explanation:

The answer is c).

We first compute the growth rate using the following formula:

  • sustainable growth rate = ROE * retention
  • sustainable growth rate = 20% * 25%
  • sustainable growth rate = 5%

The expected dividend per share = 2 *(1 - 25%) = 1.5. The cost of equity is 10%. We then can use the dividend growth model to compute the price of the stock as follow:

  • price per share = dividend per share / (cost of equity - growth rate)
  • price per share = 1.5 / (10% - 5%)
  • price per share = 30

The present value of growth opportunities (PVGO) is computed as follows:

  • PVGO = price per share - earnings per share / cost of equity
  • PVGO = 30 - 2 / 10%
  • PVGO = 10

Learn more about this topic:

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The Dividend Growth Model

from Finance 101: Principles of Finance

Chapter 14 / Lesson 3
9.8K

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