Trend-Line Inc. has been growing at a rate of 6 percent per year and is expected

Question

Trend-Line Inc. has been growing at a rate of 6 percent per year and is expected to continue to do so indefinitely. The next dividend is expected to be $5 per share.

1. If the market expects a 10 percent rate of return on Trend-Line and If Trend-Line's earnings per share will be $9, what part of Trend-Line's value is due to assets in place?

2. If the market expects a 10 percent rate of return on Trend-Line and If Trend-Line's earnings per share will be $9, what part of Trend-Line's value due to the growth opportunities?

Explanation / Answer

1) Dividend is paid out of the profit to the shareholders of the company and the current price can be estimated using the formula Po = dividend next year /(expected return - growth rate )

= $5 / (10%-6%)

Stock price = $125 will be the stock price

The assets-in-place are assumed to generate the firm's initial level of earnings-per-share (EPS) in perpetuity. This is valued at a discount rate (k). The use of EPS, rather than operating cash flow, must reflect a decision to separate out the value of discretionary opportunities which will grow the business, rather than the value of all discretionary investments which would include the maintenance of current capital assets.

Hence the formula to calculate the asset in place value = Px = EPS/k

= 9/.1 = $90

2) To compute the growth opportunities

we need to subtract the market price - asset in place

hence the vlaue due to growth opportunities = $125 - $90 = $35

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