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?
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
Become a member and unlock all Study Answers
Try it risk-free for 30 daysTry it risk-free
Ask a question
Our experts can answer your tough homework and study questions.Ask a question Ask a question
Learn more about this topic:
from Finance 101: Principles of FinanceChapter 14 / Lesson 3