3 Your financial advisor encourages you to consider purchasing a stock, is- sued
ID: 1172223 • Letter: 3
Question
3 Your financial advisor encourages you to consider purchasing a stock, is- sued by zoOT, INC., which posted earnings this past year equal to $10 per share. According to your advisor, zoT, INC. pays out 50 percent of its earnings in dividends. All new net investment, which yields a return of 20 percent, is financed entirely with the remaining 50 percent. Assume the risk-free rate of return is 8 percent and the expected rate of return on the market portfolio is 18 percent 3.1 Suppose that the stock's B is equal to 1.2. Would $54.00 be considered a fair price for this stock assuming the constant dividend growth model? Why or why not? [20 points] 3.2 Assuming that the stock is currently selling at its fair price, calculate the net present value of zoT, INC.'s growth opportunities. What does your calculation imply about the relevance of management's dividend policy for the value of the firm? [20 pointsExplanation / Answer
g = b*r
= 0.50 * 20%
= 10%
CAPM return = Rf + Beta ( Rm - Rf )
= 8% + 1.20 ( 18% - 8% )
= 8% + 1.20 (10%)
= 8% + 12%
= 20%
Fair Price = D1 / ( Ke - g )
D0 = EPS0 * Div payout ratio
= $ 10 * 50%
= $ 5
D1 = D0 (1+g)
= $ 5 ( 1 + 0.10)
= $5 * 1.10
= $5.50
Fair Price = D1 / ( Ke - g )
= $5.5 / ( 20% - 10% )
= $ 5.5 / 10%
= $55
If stock is selling at $ 54, it is underpriced, adviced to buy it.
PV of Growth Opportunities = Fair price with growth - Fair Price without growth
Fair price with out Growth = DIv / Ke
Entire Earnings paid as dividend
= $ 10 / 20%
= $ 50
PV of Growth Opportunities = Fair price with growth - Fair Price without growth
= $ 55 - $ 50
= $5
Pls comment, if any further assistance is required.
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