# 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.

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

The Dividend Growth Model

from Finance 101: Principles of Finance

Chapter 14 / Lesson 3
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