Start-Up Industries is a new firm that has raised S270 million by selling shares

Question

Start-Up Industries is a new firm that has raised S270 million by selling shares of stock Management plans to earn a 20% rate of return on equity, which is more than the 12% rate of return available on comparable-risk investments Half of all earnings will be reinvested in the firm. a. What will be Start-Up's ratio of market value to book value? (Do not round intermediate calculations.) Market-to-book ratio b. What will be Start-Up's ratio of market value to book value if the firm can earn only a rate of return of 4% on its investments'? (Do not round intermediate calculations. Round your answer to 2 decimal places.) Market -to- book ratio

Explanation / Answer

Solution:

a.

The Start-up has raised equity capital of $270 Millions

The expected rate of return on equity = 20 % of equity capiatal

                                                             =20/100 *270

                                                =54 Millions

Total Earnings from Investment is $ 54 million. Out of which half will be reinvested into firm and half will be paid as Dividends.

Therefore The Retention ratio = 0.50

According to DDM model,

Growth rate of dividends = ke*r

Here,

ke is return on equity

r is retention ratio

Growth rate of divedends = 0.20 *0.50 = 0.10

Market price = Dividend paid /ke -g

                      = 0.5*54//0.12-0.10

                     =1350 Millions.

Market to book ratio = $ 1350 Millions

Market to book ration = $1350/ $270 =   5

                                      

If Firm's Return on investment is 10%

The

The expected rate of return on equity = 4 % of equity capiatal

                                                             =4/100 *270

                                                =10.8

Total Earnings from Investment is $ 270 Million Out of which half will be reinvested into firm and half will be paid as Dividends.

Therefore the Retention ratio = 0.50

According to DDM model,

Growth rate of dividends = ke*r

Here,

ke is return on equity

r is retention ratio

Growth rate of divedends = 0.04 *0.50 =0.02

Market price = Dividend paid /ke-g

                         = 10.4 *0.50/0.12-0.02 = 52

   

Market to book ratio = 52 / 260 = 0.2

  

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